If you have decided to devote your time and money to the field of trading, it is important to understand that risk-free trading is a myth. As a rule, in the course of transactions, each trader's chances of winning or losing are 50/50. In spite of the fact that in trading, the result largely depends on chance, the ratio of profit and loss can vary depending on the individual strategy. What is profit and loss? How do you strike a balance to succeed on the trading floors? Let's read about it in this article.
Some platforms provide for the possibility of early exit from the transaction at the discretion of the trader who notices that he or she is losing. However, this option is not suitable for everyone, because this way he is guaranteed to lose part of his capital.
Only well-planned funds management, i.e. correctly chosen financial strategy, will allow reducing risks in order to maintain the optimal level of cash flow. We are talking about optimal portfolio composition, diversification of risks, analysis of the volume of investments in a certain market, evaluation of the balance of potential profit and loss, choice of tactics and style of trading platforms in general. Let us stress once again: in trading, risks can be minimized, but not 100% of them can be avoided.
About Profit and Loss Ratio
Let's face the truth: most trades are non-profitable. The best trader in the futures market is the one who makes more profit trades than loss trades. This is possible as a result of the analysis of the ratio of potential profits to losses.
For all potential deals the profit rate should be determined. Subsequently it must be balanced with the amount or percentage of possible losses (there is always the possibility that the market direction can become undesirable).
As a rule, the ratio is usually set as 3:1, where 3 is a potential profit, which should on average three times exceed the amount of possible losses. I.e., if the amount of predetermined risk is $100, then the amount of potential profit should be $300 or more.
If the indicators are different, it should be postponed before entering the market.
The importance of the average rate of return per trade
The profit/loss ratio is an important indicator, but one should not forget about the average return per trade. It is what determines the success of a trader's trading activity.
The level of average return per trade (ARRT) can be calculated by the formula by setting the size of a potential (PW) and average (AW) gain as well as index of a probable (PL) and average (AL) loss.
APPT = (PW×AW) - (PL×AL)
Average return per trade taking into account different scenarios.
The trader places 10 trades. 3 - make profit; 7 - incur losses.
I.e. the profit is 30% (0.3%), and the loss is 70% (0.7%) of the total number of deals (1). In other words, the sum of average profit for a trade is twice as big as the average loss.
The ratio of profit and loss is 2:1. This trading approach ensures that only 30% of profitable trades are made.
Trader places 10 trades. 8 of them are profitable; 2 of them are losing.
Even when the profit/loss ratio is 1:3, APPT is positive. By choosing this approach to trading, you can soon be in profit.
About Periodic Profitability Calculations
The world of finance has adopted a common standard that allows you to compare different investment options. The assessment of profitability is taken into account as a percentage per annum. The period can be a week, a month, a year, etc.
We use a simple formula for return. Dividing the income for any period by the investment term in days and multiplying by 365 (if the year is a leap year, multiply by 366).
An example of calculating the average rate of return on an investment
Investment of 12 months: $10,000
Investment over 24 months: - $20,000. Total return: $10,000 (yearly income + 100%).
Investment within 36 months: Profit on investment up to the original amount of $10,000. A loss of $10,000 (annual return - 50%).
The average return on this investment is 25%. The result is calculated as follows:
Each year we add a profit (+100% and -50%) and divide the result between 24 months. It came out $10 000, i.e. coincidence of the final amount of investment with the initial one.
That is, it turns out that the total return on investment - 0%, although the average return of +25%.
The reason for obtaining such figures is the use of arithmetic means of return instead of geometric, which is not entirely correct.
The correct estimate of the average annual return is calculated using the geometric mean formula.