Risk/Reward Ratios And Hit Rate
Measuring your trading success
When you first begin Forex trading, its vital that you epxand your knowledge of trading fundamentals. These include macroeconomic analysis, technical analysis, charting, and an understanding of the psychological impacts of trading. It’s also critical that you develop an approach to managing risk. Understanding risk comes from an apreciation of the different metrics that measure the success of a given trading strategy or system. Analysing different measures of trading success makes it possible to improve the results of any trading system or strategy, heightening profit potential and the returns from assets under management.
In this section, we’ll look at two of the key metrics that you can easily measure and analyse in to improve your understanding of trading performance and the effectiveness of your overall strategy.
- The Risk/ Reward Rate
- The Hit Rate
We’ll also look at how both can be combined and analysed.
Risk/Reward Ratio defined
The Risk/Reward Ratio is a measure of the potential reward or profit that a trader or investor can expect from any given investment in terms of the potential risk of loss.
For examle: if a trader was willing to risk losing £2 on trade and the potential profit target was £10, then the Risk/Reward Ratio would be 2:10 (or simplified to 1:5).
It should be noted that any calculation is based on some hypothetical inputs. You can have a good idea of your potential risk by establishing a stop-loss (see our article on stop-losses here). The potential reward or profit is only a projected expectation before the trade or investment has even been entered into.
Risk/Reward in practice
You’ve done initial analysis on the gold market and have decided you want to buy the equivalent of $1 per point movement. The current offer rice on gold is $1100, and you have a target for the next month for gold to reach $1200.
This would then give you a potential profit of $1200-$1100, which is $100. By analysing your chart, you might see that there is strong support for gold at $1060, and decide to lace a stop-loss just below this support at $1050.
This would then indicate a potential loss of $1100 minus $1050, so $50. The possible loss on the trade, therefore, as a ratio to the potential profit on the trade is $50 to $100, which gives you a 1:2 Risk/Reward Ratio.
Clearly, the higher the Risk/Reward Ratio, the better the prospects for more substantial profits overall, but it’s vital also to consider how often your strategy is successful in picking winning trades.
This brings us to the Hit Rate.
Risk/Reward Ratios and Hit Rate
The Hit Rate is typically defined as the number of winning or profitable trades over a period of time for a trading strategy, divided by the total number of trades over the same period, and expressed as a percentage.
For example: if you have a trading strategy where you enter ten trades over a one-month period, and of these, six trades are winning trades, and four are losing trades, the hit rate is 6÷10, expressed as a percentage, which is 60 per cent.
The Hit Rate is also sometimes expressed as a Win/Loss Ratio, or the number of winning trades divided by the number of losing trades to create a ratio. In the above examle, this would be 6:4 (or reduced to 3:2).
Although the Hit Rate is an important metric and measure of the potential success of a trading strategy, it does not take into consideration the monetary value of each winning or losing trade.
For this reason, it is useful to combine the measures of Hit Rate and Risk/ Reward Ratio to have a better understanding of the potential profitability of your trading strategy.
Hit Rate and Risk Reward Ratios combined
For any trading strategy, profitability and success will always be a trade-off between the Hit Rate and Risk/Reward Ratio.
In most trading systems, achieving a higher Hit Rate usually means waiting for confirmation that the trade is going to be successful, which generally then lowers the Risk/Reward Ratio.
Conversely, improvements in the Risk/Reward Ratio usually mean entering a trade at an earlier stage, which is sometimes detrimental to the Hit Rate.
It’s the relationship between the Hit Rate and Risk/Reward Ratio that determines if a strategy will be profitable.
Let’s look at an example:
Trader 1: Profiting with a high Hit Rate and low Risk/Reward Ratio.
- Hit Rate 60% and Risk/Reward Ratio 10:6 (or 5:3)
- 10 trades, 6 wins of £60, four losses of £100
- Outcome: £40 loss
Trader 2: Losing with a High Risk/Reward Ratio and low Hit Rate.
- Hit Rate 30% and Risk/Reward Ratio of 1:3
- Ten trades, three wins of £300, seven losses of £100
- Outcome: £200 in profit
So, in the diagram below, any combination of Hit Rate and Risk/Reward Ratio above the curve indicates a profitable
strategy, while any combination below the curve results in a losing strategy.
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