The most comprehensive in history: detailed explanation of 3 profit and loss rat

2024-05-28

I've noticed that many traders are unaware of what the profit-to-loss ratio is, nor do they know how to calculate it. People tend to habitually focus on the win rate/success rate, often overlooking the importance of the profit-to-loss ratio. In fact, within a complete trading strategy, the profit-to-loss ratio is even more important than the win rate because it directly determines the profitability level of the entire strategy. So today, I will delve into the concept of the profit-to-loss ratio, discuss how it is calculated, common issues encountered in practice, and provide a technical explanation of three types of profit-to-loss ratio patterns. I will also combine the win rate and suitable market trends for specific explanations, and these practical skills can help elevate your trading strategy to a higher level.

What is the profit-to-loss ratio?

The profit-to-loss ratio is the proportion of the profit amount to the loss amount in a trade. For example, when you enter a trade, if you set a fixed stop loss of 1000 yuan and a fixed take profit of 2000 yuan, then the profit-to-loss ratio for this trade is 2:1, and so on. You can also set a profit-to-loss ratio of 3:1, 4:1, or even higher.

The so-called fixed profit-to-loss ratio means that you exit each trade according to the same ratio, such as 2:1. If you lose, you lose 1000 yuan; if you win, you earn 2000 yuan. By adjusting the win rate, you can achieve a profitable outcome.

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There are also trading methods with non-fixed profit-to-loss ratios on the market. In this approach, the stop loss is usually fixed, while the take profit is dynamic.For instance, when entering a trade, one might set a stop loss of 1000 yuan, while the take profit follows the trend dynamically. Sometimes, when the market moves in a strong one-way trend, it is possible to make a profit of 10,000 yuan, resulting in a profit-to-loss ratio of 10:1. If the market is volatile, one might only make a profit of 1000 yuan, which would give a profit-to-loss ratio of 1:1.

What common issues arise when setting profit-to-loss ratios?

Many people's trading strategies are incomplete. Sometimes, when they are in a good mood, they might hold onto an order for a few more days, resulting in a high profit-to-loss ratio trade. Other times, when they are in a bad mood, they might engage in intraday short-term trading, frequently executing short-term orders, which leads to a low profit-to-loss ratio.

Setting profit-to-loss ratios randomly in this way makes it impossible to gather accurate trading data, and sometimes it's unclear whether the trading system is profitable at all.

The two major factors that determine the profitability of a trading system are the profit-to-loss ratio and the win rate.

We cannot rely on a single trade; instead, we must conduct thousands or even tens of thousands of trades. At this point, we need to consider the balance between the win rate and the profit-to-loss ratio comprehensively.

For example, with a profit-to-loss ratio of 2:1 and a success rate of 40%, the overall trading can be profitable. Alternatively, with a profit-to-loss ratio of 10:1 and a success rate of over 10%, the overall trading can also be profitable.

The win rate and the profit-to-loss ratio have an inverse relationship, so people often ask me if there is a trading system with both a high win rate and a high profit-to-loss ratio. The answer is no, and it is impossible to achieve.

Therefore, in our trading strategies, we must carefully consider the balance between the win rate and the profit-to-loss ratio. If the profit-to-loss ratio is too high and the win rate is too low, one will frequently face stop losses during trading, and no one can endure a high number of stop losses.

If the win rate is too high and the profit-to-loss ratio is too low, then each profit will be minimal, and sometimes it will take many profitable trades to recover from a single loss, making the trading experience unsatisfactory.Next, I will combine the win rate to explain three strategies for setting the profit-to-loss ratio, and at the end, I will also teach everyone how to choose a strategy that suits themselves.

Strategy 1: High Profit-to-Loss Ratio

A high profit-to-loss ratio means that the ratio of the trading system is at least 5:1, or even higher. This means that for each trade with a stop loss of 1,000, the profit should be at least 5,000 or more.

The profit pattern of this trading system is that when the order is wrong, the stop loss is small, and when the order is profitable, the profit is large, but the success rate is usually low.

Although there may be many wrong times, the amount of a large profit can cover the losses caused by frequent small stop losses, and the overall profit is achieved.

For example, with a 5:1 profit-to-loss ratio, the trade has a stop loss of 1,000 and a profit of 5,000, with a success rate of 20%. In 100 trades, 20 are correct, with a profit of 100,000, and 80 are wrong, with a loss of 80,000, resulting in an overall profit of 20,000.

Those who adopt this mode are usually trend-based trading strategies.

Let's go into the specific technical explanation.

To achieve a high profit-to-loss ratio in trading results, the trading system should set a large profit target position when setting the exit, and at the same time, try to control the stop loss space when entering the market, with a small stop loss and a large profit target to achieve a high profit-to-loss ratio.

Among all the exit methods, the trend-following exit method is the most likely way to hold a large space.The chart shows a 1-hour candlestick chart of the Euro (EUR) against the US Dollar (USD), where the market has formed a breakout from a rectangular consolidation pattern at the top.

Control entry with a stop loss.

If you enter directly after the breakout, place the stop loss at the high point of the consolidation pattern at 1.11750. The stop loss space is quite large, 450 pips, which is not conducive to achieving a high reward-to-risk ratio.

Therefore, do not enter the market immediately after the breakout. Wait for the market to retrace and form a reversal candlestick before entering. In the chart, after a reversal hammer candlestick formed, that's when you enter. The stop loss space is only 100 pips.

The stop loss space is compressed by 350 pips. Do not underestimate these 350 pips. With the same reward-to-risk ratio of 5:1:

With a stop loss of 450 pips, to achieve a 5:1 reward-to-risk ratio, you need to profit 2250 pips.

With a stop loss of 100 pips, to achieve a 5:1 reward-to-risk ratio, you only need to profit 500 pips.

Traders with actual trading experience understand that holding onto a profit of 2250 pips is many times more difficult than holding onto a profit of 500 pips. Just the extended holding period is a great test of our trading psychology.

Let's continue to look at the subsequent trend chart.

The chart shows the 1-hour trend candlestick chart after the order entry from the previous image.Use a trailing stop exit strategy.

After the order is entered and the market starts to decline, adjust the stop loss each time a turning point of an upward rebound breaks. There are 5 opportunities to adjust the stop loss in the chart, represented by the 5 red arrows. After the 5th adjustment, the market reverses and breaks through the trailing stop loss, closing the position.

The entry price was 1.11310, and the exit price was 1.10150, resulting in a profit of 1160 pips.

With a profit of 1160 pips and a stop loss of 100 pips, the risk-reward ratio is 11:1.

Without controlling the stop loss, the stop loss space would be 450 pips, and the profit would be 1160 pips, resulting in a risk-reward ratio of only 2.5:1, which is a significant difference.

Details determine the profit and loss of a trade.

Precautions for high risk-reward ratio trading strategies:

(1) In daily trading, setting stop losses is the norm, but each stop loss is small, and the success rate of entering with a small stop loss is not high.

The example given above is a very smooth bearish trend, with a one-time successful entry on a reversal candlestick. However, in practice, the success rate of entering on a single candlestick reversal is not very high, not exceeding 30%, and you may encounter consecutive stop losses in a consolidating and correcting trend.

Other entries with small stop losses also have this characteristic; in practice, be prepared to face a series of wrong trades, and don't let the streak of losses wear away your patience and confidence, affecting your trading mentality.(2) When encountering favorable market conditions, it is crucial to hold positions firmly and secure substantial profits. One must not be indecisive. Only by doing so can significant profits offset the multiple losses from small stop losses, ultimately leading to profitable trading.

Strategy 2: Positive Reward-to-Risk Ratio

A positive reward-to-risk ratio refers to a trading system where the ratio of profit to loss is positive, meaning the amount of profit exceeds the amount of the stop loss, but it is not as high as a high reward-to-risk ratio. For instance, a 2:1 reward-to-risk ratio implies a stop loss of $1,000 and a profit target of $2,000.

The profit model of this type of trade is to capture a segment of the market's profit space and secure it promptly. The difference between the stop loss and the take profit is not very large, requiring a higher success rate of orders. Profits from correct orders must outweigh the losses from incorrect orders to achieve overall profitability.

For example, with a 2:1 reward-to-risk ratio, a stop loss of $1,000 and a profit target of $2,000, and a success rate of 40%, out of 100 trades, 40 are correct, yielding a profit of $80,000, while 60 are wrong, resulting in a loss of $60,000, leading to an overall profit of $20,000.

Let's proceed with a detailed technical explanation.

To achieve a positive reward-to-risk ratio in trading outcomes, the trading system can be set with a fixed reward-to-risk ratio upon exit. For example, a fixed stop loss of $1,000 and a fixed take profit of $2,000 can be set. Once the order reaches the take profit price, it is closed, and the next opportunity is sought.

The chart below is a 1-hour candlestick chart of the Euro to US Dollar exchange rate.

After the market experiences a break from the top rectangle consolidation, it enters a position after a callback confirms a second break. The entry price is 1.11090, the stop loss is set at the high point of the callback, 1.1410, with a stop loss space of 320 pips, and the take profit is set at twice the stop loss space, 640 pips, with a take profit price of 1.10450.

Let's continue to observe the subsequent trend.The chart shows the trend after the order is placed at the top. After a series of declines, the market takes profits at a low position with a profit-to-loss ratio of 2:1.

Precautions for a positive profit-to-loss ratio trading strategy:

(1) It is easier to control the mentality. The success rate of trades is relatively high, and the distribution of right and wrong trades is also balanced. The fluctuation of the amount of profit and loss in trades is small, leading to less mental fluctuation and a more stable mentality. Therefore, the execution difficulty of such a trading system is relatively low.

(2) The execution difficulty is low. A trading strategy with a positive profit-to-loss ratio requires less attention to the market. After placing an order, set the stop loss and take profit, and then you can let the market run without watching it. It is suitable for traders who do not have much energy to watch the market, and the technical standards are relatively simple and easy to execute.

(3) It is common to encounter situations where the order takes profit, and the market continues to move in a large space. With this trading model, be prepared to miss out on big market movements. Don't feel sorry for missing out; just earn the money you should earn. After all, in some wide-range volatile markets, orders with a positive profit-to-loss ratio can also take profits in time, but similar markets may result in losses with a high profit-to-loss ratio trading strategy.

Strategy 3: Negative Profit-to-Loss Ratio

A negative profit-to-loss ratio means that the profit-to-loss ratio of the trading system is negative, with the amount of profit being less than the amount of the stop loss. For example, the profit-to-loss ratio is 1:2, the stop loss is 1000 yuan, and the profit is 500 yuan.

This type of trading is generally for short-term trades with a relatively short holding period. Although it is a negative profit-to-loss ratio, the difference between the stop loss and take profit is not particularly large. Usually, the stop loss is only slightly larger than the take profit. To achieve profits with this trading method, a very high success rate is required.

For example, with a 1:2 profit-to-loss ratio, a stop loss of 1000 and a take profit of 500, an 80% success rate. In 100 trades, 80 are correct, with a profit of 40,000, and 20 are wrong, with a loss of 20,000, resulting in an overall profit of 20,000.

Let's proceed with a detailed technical explanation.A trading system with a negative profit-to-loss ratio can also directly set a fixed profit-to-loss ratio for exit, for example, if the stop loss is 1000 yuan, a fixed take profit of 500 yuan can be set, and the order is closed once the take profit price is reached, looking for opportunities to re-enter the market.

The chart shows a 1-hour candlestick chart of the Euro to US Dollar exchange rate.

The market broke through the top rectangle consolidation and entered short directly after the closing, with the stop loss set at the high point of the consolidation pattern. The entry price was 1.11260, the stop loss price was 1.11740, with a stop loss of 480 pips, and the take profit was set at 240 pips, with the take profit price at 1.11020.

After the order entered, the market had a retracement to test the pressure upwards. Since the stop loss was at the high point above, there was a large space for the stop loss, and the market retraced without triggering the order's stop loss. After the retracement ended, the market continued to fall, and the order was taken profit.

Precautions for negative profit-to-loss ratio trading strategies:

(1) There are many correct orders in the trade, the psychological pressure in the trade is relatively small, and the difficulty of execution is also small.

(2) Achieving a high success rate in trading requires a high level of trading skills, and short-term trading also requires a high level of self-discipline from traders. It requires very experienced traders to do well in this mode.

(3) In practice, there are also models that improve the success rate by building positions in batches and making continuous trial and error, such as building positions in three batches for a reversal opportunity, bottom fishing three times, averaging the price, and achieving a higher success rate. Grid trading in stock trading is such a continuous bottom fishing and averaging the price, with a high success rate and negative profit-to-loss ratio trading model.

How to choose among several profit-to-loss ratio models?

The second model is what I am currently using myself because it is a middle ground between the two models, with a moderate success rate, fewer consecutive errors in trading, and better control over trading mentality. At the same time, this model does not require high trading skills, and the operation difficulty is the lowest, suitable for the majority of traders.In the third pattern, the difference between profit and loss amounts is not significant. Due to the relatively high success rate, the mindset is also easier to control, making it a good choice.

The first pattern is the most difficult because it demands a lot from one's mindset, requiring a longer holding period and having experienced many consecutive losses, which can sometimes lead to a loss of patience and confidence. However, if you have a strong mental resolve and can ensure that you capture every significant profit, this method is also viable.

What I am doing myself is swing trading, and I use the second pattern with a fixed profit-loss ratio for exiting positions. The choice of which pattern to adopt also depends on what your trading strategy is and which one suits your personality better.

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