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Trading Education Posted by Team Topstep May 29, 2018

The Most Important Metric in Trading (Hint: It’s Not Your P&L)

Metrics can be a lifesaver for a trader. Without a way to evaluate your strategy, each trade is little more than a roll of the dice. Yes, there’s an element of chance in the markets. But you can’t depend on things going your way if you want to be consistently profitable.

Certainly there are a lot of metrics that are interrelated that will ultimately bleed into the bottom line. But, as we have talked about in the past, if you are only focused on your bottom line, you are going to have a tough time trading.

So what’s the best metric to look at? The risk-to-reward ratio. Broken down, this tells you how much you lose on an average losing trade versus how much you gain on an average winning trade. Other metrics, like your net profit / loss, may make your feel good, but your risk-to-reward gives you information you can use to actually get and sustain that healthy account balance. Here’s how.

What is the Risk-to-Reward Ratio?

The reason you’re trading is because you want to make money. However, every trade also has risk attached to it. The risk-to-reward ratio measures your potential losses against your anticipated profit.

This can be calculated on a per trade basis by placing stop or limit orders and then letting the trade play out until one is hit. If your stop is three E-mini S&P ($ES) points away and your profit target is nine points away, your risk-to-reward ratio is 1:3. If you always have that same ratio, then your risk-to-reward will be 1:3 across your entire account. 

Because actual trading varies from targets, we provide all the data that you need to get this information on your Trade Report. Below is a sample Trade Report from Z.S., a funded trader from New Jersey.

ZS Dashboard

In his Funded Account®, you can see that Z.S. makes an average of $198.15 on his average winning trade and loses an average of $126.71 on his average losing trade. That’s a risk-to-reward ratio of 1:1.56. 

Why is My Risk-to-Reward Ratio Important?

The risk-to-reward ratio tells you a number of important things, including:

  1. How often do you have to be right? The math is simple, in order to be profitable trading, you have to make more money than you lose. If on any given trade you are willing to accept $100 in profits or take $100 in losses, you have to be right more than 50% of the time in order to be profitable (otherwise, over the long term, you’d make and lose the exact same amount). 

    As is the case for Z.S. above, the simple fact that his average winning trade is 1.56x as large as his average losing trade means that he can be right less than 50% of the time and still be profitable. Z.S. is, in fact, profitable with just a 41.35% winning trade percentage. That is the holy grail because not all trading strategies will work in all environments.

  2. Whether your risk is out of hand. Believe it or not, but there are traders that have 60% winning trades, but are unprofitable. Why? Because their risk is out of hand and they lose much more on the 40% of trades than they make on the 60%. They don’t let their winners run and cut their losses short   and that’s the kiss of death for a trading account. 

  3. Whether you’ve been lucky or consistent. Your risk-to-reward ratio is a check on your P&L. You cannot expect your winning trade percentage to be above 65 or 70% on a consistent long-term basis — no successful trader (outside of computer-driven HFT firms) has a winning percentage that high. That’s why your P&L can lie to you. You can have a huge P&L that is only there because you’ve been right a large majority of the time. 

    If instead, you have a high P&L while keeping your risk-to-reward consistent, then you can take comfort in knowing that even when your trading encounters challenging environments, you will remain profitable. 

  4. It tells you your expected return. This is slightly math-heavy, but follow us. If you know your average winning and losing trade size AND your winning trade percentage (all numbers we provide on the Trading Dashboard), then you can actually calculate how much you are expected to make per trade — winners and losers included. 

    Here’s how:

    (Average Winning Trade * Winning Trade Percentage) (Average Losing Trade * Losing Trade Percentage ) = Expected P&L per Trade

    Using Z.S. above:

    (198.15 * 0.4135) − (126.71 * 0.5865) = $7.62 expected P&L per trade

    To increase the amount of profits you make in one day, you have a few levers to pull. You can either make more trades (keeping the risk-to-reward and winning trade percentage constant), which is a risky endeavor, or you can try to increase your winning trade percentage or lower your risk-to-reward. 

    For Z.S., he’s working on bringing up his winning trade percentage, keeping his risk-to-reward consistent. If he brings his winning trade percentage to 50%, then his expected P&L per trade increases by 5x to $35.72. 

    (And yes, we could’ve picked a trader with a better expected value to show you, but we chose the most recent highlighted funded trader for transparency and insight into the challenges and successes that all traders face.)

What should your risk-to-reward ratio be?

OK, so what number should you be targeting? Again, that’s a moving target based on your strategy and winning percentage. 

But as a general rule of thumb, TopstepTrader Senior Performance Coach John Hoagland — a 25+ year trading veteran — recommends a minimum that traders should try to make 2x as much on their winning trades as they lose on the losing trades. That will allow them to be profitable trading whether they are successful 60% of the time (as we are in the good times) or 40% of the time (as we may be in the bad times). 

By telling you all these things, the risk-to-reward ratio is the most powerful metric in trading. If you want to increase profits, it’s the best place to start.