Relation between Win Ratio and Risk Reward
Have you ever seen videos boasting a 99% win rate? Or have you seen the social media posts saying huge risk-reward? And did you wonder how they make it while you lose every trade attempted?
The simple answer to this is, what they advertise is a half-truth!! That's because people claiming both these things do not talk about other side of the coin.
Two sides of the coin
- People often asked me if a strategy win rate is less than 50% then why do we need to follow it? And also we can see in social media - lots of people claiming 90%+ win ratio for their strategy.
- There is also another set of people who are more infatuated with how much percent profit they can get out of strategy. In social media, we can see people bragging about 1000% + profit trades.
The question here is, is it really possible to achieve this consistently or is the expectation to achieve such success reliable? Simple answer for this is yes, it is possible to achieve both 99% win rate and 1000%+ profitability. But, it is almost impossible to achieve both together.
Thing we need to understand is, If the strategy supposedly has a 99% win rate, then it will likely have a very low-risk reward that even losing 1 trade will bring more loss than the gain of winning 99 trades. Similarly, when the risk reward is very high, it is likely that their win ratio is very less and hence probability of winning such trades are very low.
The conclusion is,
- We can have 99% win rate and still lose money!!
- We can have 1000% profitable trades and still lose money!!
Example 1 : Option Selling for premium
Selling options is very popular trading strategy which can often have very high win rates. But, the risk reward for this is very low.
99 X $1 = 99 profit
1 X $100 = 100 loss
Example 2 : High Leverage Trades When you are trading with high leverage, profits and losses are magnified. This may lead to lots of losses and also some trades with huge profit. Lets say you are targeting 1000% win per trade with 100X leverage. This means, your position is liquidated upon 1% price drop or less. So, your threshold for withstanding drawdown in a trade is less. To make 1000% profit, the price need to go up by 10%
Risk = $1 Leverage = 100X Buy price = 100 Your position will liquidate if price hits 99. So, by just 1% drop. To achieve 1000% profit, price need to go up by 10% This means, your expectations of profit per trade is very high. This also mean, you are most likely to have more failed trades than wins. So, lets say you will end up with Win ratio of 5% with this expectation. The equation can look something like this.
5 X $10 = 50 profit
95 X $1 = 95 loss
What we learn from above examples is that there is no meaning of considering only Win Ratio or only Risk Reward while trying to build your strategy. What you need to consider is the combination of both together.
Here is a formula to understand how much win ratio do you need to breakeven with given risk reward. Win Ratio = 1/(Risk Reward+1) Similarly here is a formula to understand how much Risk Reward you should target to breakeven with given win ratio. Risk Reward = 1/WinRatio - 1 Here is a Google sheet containing the formula applied on various values.
You can use this formula to understand overall profitability while building or evaluating strategies.