Win Rate vs Risk/Reward Ratio

Understanding the relationship between win rate and risk/reward ratio is crucial for developing profitable trading systems. This lesson explores how to balance these two factors. [DEFINITION] Risk/Reward Ratio (R:R): The relationship between potential profit and potential loss on a trade, expressed as reward divided by risk. A 2:1 ratio means potential profit is twice the potential loss. ### The Win Rate - Risk/Reward Tradeoff High win rate systems: - Small winners, tight targets - Require large average win relative to loss - Psychologically comfortable (frequent wins) - Risk: One big loss wipes many wins Low win rate systems: - Large winners, wide targets - Can tolerate many losses - Psychologically challenging (frequent losses) - Benefit: Winners significantly exceed losers [KEY] Win rate and risk/reward are often inversely related. Higher R:R targets typically reduce win rate. You choose where to position on this spectrum. ### The Break-Even Table Minimum win rate needed for different R:R ratios: | R:R Ratio | Break-Even Win Rate | |-----------|---------------------| | 1:1 | 50% | | 1.5:1 | 40% | | 2:1 | 33% | | 3:1 | 25% | | 4:1 | 20% | [FORMULA] Break-Even Win Rate = 1 / (1 + Risk/Reward Ratio) ### Choosing Your Style **High win rate approach:** - Target: 60-70% winners - R:R: 1:1 to 1.5:1 - Example: Scalping, mean reversion - Psychology: Need discipline to cut big losses **Balanced approach:** - Target: 45-55% winners - R:R: 1.5:1 to 2:1 - Example: Swing trading - Psychology: Comfortable balance **Low win rate approach:** - Target: 30-40% winners - R:R: 2:1 to 3:1+ - Example: Trend following - Psychology: Must accept many small losses [EXAMPLE] Trend followers like Richard Dennis (Turtle traders) won only 35-40% of trades but were highly profitable because winners were 2-5x larger than losers. ### Why Low Win Rates Can Be Better **Compounding big winners:** - Trend following captures large moves - One big winner pays for many small losers - Requires patience and discipline **Lower false positive damage:** - Quick stop-outs limit loss per trade - Allows for many "experiments" - Right bets generate asymmetric returns [TIP] Many of the most successful traders in history had win rates below 50%. Don't equate win rate with skill or profitability. ### Why High Win Rates Can Be Dangerous **The 90% win rate trap:** - Feels great... until it doesn't - Often achieved by avoiding stops - One catastrophic loss wipes out everything - Example: "Never take a loss" strategies that eventually blow up ### Finding Your Balance Consider: 1. Your psychology (can you handle frequent losses?) 2. Your trading style (scalping vs position trading) 3. Market conditions (trending vs ranging) 4. Time commitment (higher win rate may require more activity) [EXERCISE] Your current stats: 55% win rate, 1.2:1 R:R ratio. Expectancy = (0.55 × 1.2) - (0.45 × 1) = 0.66 - 0.45 = 0.21 per $1 risked. How would expectancy change if you moved to 40% win rate but 2.5:1 R:R? |ANSWER| New expectancy = (0.40 × 2.5) - (0.60 × 1) = 1.0 - 0.6 = 0.40 per $1 risked. The lower win rate, higher R:R approach nearly doubles your expectancy (0.40 vs 0.21). Of course, you need to determine if this shift is actually achievable in your trading. ### Adjusting Your System **To increase R:R:** - Widen profit targets - Tighten stop-losses (may reduce win rate) - Be more selective on entries **To increase win rate:** - Take quicker profits - Accept smaller R:R - Improve entry timing ### Common Mistakes [WARNING] Common errors: 1. Chasing high win rate by holding losers too long 2. Moving stops to avoid losses 3. Taking profits too quickly (kills R:R) 4. Not aligning psychology with system requirements [SCENARIO] You're testing two systems. System A: 65% win rate, 1:1 R:R. System B: 45% win rate, 2:1 R:R. Which should you choose? Calculate expectancy: System A = (0.65 × 1) - (0.35 × 1) = 0.30. System B = (0.45 × 2) - (0.55 × 1) = 0.90 - 0.55 = 0.35. System B is slightly better mathematically. But also consider: Can you handle 45% win rate psychologically? Which fits your trading style? Both are profitable—choose what you'll actually execute consistently.