How does the profit to risk ratio change with different trading tactics, quality of the transaction, risk management.
As you may remember our previous posts, in trading, managing losses is as important as in any business to influence the difference between revenue and expenses.
Business controls profits through a budget, trading through a trading plan. In the trading plan, risk and money management is responsible for profitability.
Forgive our bold summary, but risk management is responsible for the maximum profit in trading*
* meaning “control point”, not a “button loot”
Market exit points:
- We need Take Profit to collect the maximum profit.
- Stop Loss will be with a pre-planned loss.
>>> Read also: At what point to fix the loss: 3 ways to calculate the Stop Loss mark
Quality of the transaction = profit / loss
Some people think that the income is formed by the size of the transaction: just close it with a maximum profit and lose less. But it is not so.
To have a stable income, not from time to time, you need to have a correct profit and loss proportion. This is called transaction quality.
The quality of the transaction helps to decide whether it is appropriate to do something at all. It shows whether you earn more than you risk and if it is so, how much.
- Quality is considered not “in general”, but for each transaction — this is important.
The specific indicator has been worked out: what potential profit to risk ratio do we need? Check it out:
2:1 rule
The ratio of potential profits and losses in each transaction must be 2: 1 or more.
What does it mean
This means that if you earn at least two times more than you risk losing, then go ahead. If the amounts are equal, then sit and wait for a good moment.
Sometimes the profit-risk ratio is higher than 2:1–3:1, 4:1, 5:1. This is a great ratio. The problem is that it does not occur so often.
“Two to one” is enough.
How to calculate profit and loss ratio:
- Determine the Take Profit value with ATR method adjustment
- In the same way, we determine the SL mark
- Calculate the profit-risk ratio:
- For purchase transactions we have a formula:
(Mark TakeProfit — Entry Price) / (Entry Price — Stop Loss Mark)
- For sale transactions we have a formula:
(Entry price — Take Profit mark) / (Stop Loss mark — entry price)
4. For not aggressive tactics, the normal ratio is 2:1.
5. For aggressive tactics, a 5:1 ratio and higher.
Let’s consider the profit-risk ratio in case of breakdown trading
In the picture you can see the candlestick opened and closed above the resistance level: a signal for those who trade using a breakdown, it shows that you can enter the market during an upward moving.
Entry price is $101, Take Profit — $105
Install StopLoss on the first of the three options: in the area of the formed level, in our example the support level, $99.
According to the second property of the levels, the price will bounce off the line rather than pierce it: take the ATR, and find the distance from the line, in order not to have any correction. So, we have the correction Take Profit value = $104.89:
- We’ll find a profit potential:
To do this, take the distance in the target: the price of exit with profit, and the entry mark:
On the traditional markets, potential profit is counted in points, in a cryptocurrency it is possible to use units from the coin stats: the trading history of some coins shows changes in pennies, the second group in units, the third in tens, and so on up to hundreds, and thousands of dollars.
- The next step is to calculate a potential risk:
- Let’s find the Stop Loss mark,
- We specify it with the help of ATR but with other calculation factors;
- We find the size of the potential risk. The logic of this formula is the same: purchase price minus exit mark with a loss.
We have:
- The most important step is to check the 2:1 rule
389 / 211 = 1.84
We have a borderline value. Any rule has an exception, so we round up to two🙂.
If the ratio was 1:1, 0.8:1 or 0.1:1, then you should not round up.
when the trading for sale
At the entrance to the sale, it is also important to take into consideration the quality of the transaction. There everything is the same, but vice versa.
Take Profit is waiting “below”, so
- (Entry price — Take Profit)
StopLoss is “above”, so
- (Stop Loss — entry price)
An example of the calculation while trading using break out
Let’s suppose that after piercing the resistance level, the market followed a correction, and it pierced the level again, upside down, and bounced off it. You see the first white candlestick to close, and for you, it is not just some kind of white candlestick but a real break out signal. You need to decide whether it is worthy of entering.
You make the same operations, as during the breakdown trading, and get something like this:
Profit potential will be 439, loss — 161
The goal is the same as in the breakdown trading, but the profit potential is higher. The entry price is more favorable than the one we saw at the time of the breakdown level, and the potential risk is less.
Profit to risk ratio is in the 2.7, which is slightly more profitable than during the break. It was an important example of the difference between the trade on the breakout and the breakdown. Such a situation is typical, we’ve mentioned it in detail a bit earlier.
An example of a calculation on the break out at the non — formed level
Last time we’ve discussed that Stop Loss is placed on one of three scenarios. The option to put SL, if the level has not formed yet, is the most aggressive one but it gives a minimal stop.
In reality, it looks like this:
You see that the extreme white candlestick has closed, and suppose that after this the price will go upwards, enter the market on this candlestick, its mark is $100.25. You set Stop Loss slightly below the entry point, where the support level is formed if the possibility of growth is confirmed.
If it is not very clear, look at the last post, we analyzed it in details.
What do you have:
You will receive the minimum amount of possible risk, 5–6 times less in comparison with other tactics. If the goal is in the same place as for the tactics above, then the profit-risk ratio is high: 439 to 35 = 12: 1.
A great result, a dream, not a result, it is the only way to live now. OK, just remember that these results are knocked out regularly.
Do you remember the main trading rule: more risk — higher your profit?
Therefore, such high-risk tactics should be used if the profit-risk ratio is not less than 5:1.
Sometimes you have to open one, two, three transactions in order to get a result.
Conclusion
- The quality of the transaction — the ratio of potential profit to loss.
- The ratio of profit to loss — the calculation of how much you can earn and how much to lose in each particular transaction. We can say that this is a mathematical understanding, so whether to open a deal, or …
3. It is important to find this ratio before each decision to enter the market and forget about emotions forever if you have not forgotten.
4. In the trade plan, the profit to loss ratio is the fourth item. For obvious reasons, this is where most of the deals are eliminated.
5. The minimum quality of the transaction is while trading on the breakdown. In our example — 1.84.
6. Trade on a break out gives a higher profit/risk ratio, in our case 2.72.
7. Setting a stop order at a level that has not yet been formed is the most aggressive option, it gives the maximum quality of the idea. In our example, quality = 12.54.
8. The minimum ratio profit to risk is 2:1. It is OK to make exceptions but it is important to be sure that the majority of your transactions does not consist of exceptions.
9. High profit potential is the only reason to use a short stop. If with aggressive tactics, you see a profit-risk ratio is less than 5: 1, you should refuse.
You should remember that more practice, more stats, higher chance to have a correct decision.
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