Every trader wants to make more on his winning positions and lose less on the losing positions. In online trading, this can be done with a profit vs. loss ratio.
What is Profit vs Loss Ratio?
Profit vs loss ratio measures the ability of a trading system to generate profits and avoid loss. It is calculated by taking average profit from all winning trades divided by average losses on all losing trades over a period of time.
Many beginners try relying on the profit vs loss ratio because it lets them make as much profit as possible by avoiding as much loss as possible. However, this simple approach can be misleading. If you use it within a large context of indicators and measures, it can do more harm than good.
Calculating Profit Vs Loss Ratio
Step 1: Determine the price of your investment. If the stock price is $10 per piece and you have bought 100 shares, the price of the investment is $100.
Step 2: Determine the expected profit from your investment. Suppose that the price per share is expected to reach $19. In that case, your profit will be $1,900.
Step 3: The ratio of profit to loss is written as profit: loss. For this investment, your ratio will be 1,900:1, 000.
Step 4: Now simplify the ratio. Divide the profit and loss with a common factor. In this case, when you divide both by 1,000, you get 1.9:1. This ratio indicates that your investment was mildly profitable.
How to Set It Up?
Now let’s move on to the real deal i.e. how to set up profit vs loss ratio. No matter what ratio you choose, it will be composed of two factors – the maximum loss percentage per trade and target profit percentage per trade. As long as you know these, you know your ratio.
According to William O’Neil, the founder of CANSLIM, the best ratio is 3:1. This means that you can be wrong twice in a row and still make a profit by being right the next time.
So, when your profit vs loss ratio is 3:1 and let’s say you want to cut your losses to 7 to 8 percent each trade at max, this is how it will play out. When you buy a position, you are immediately placing a stop loss order 7 or 8 percent below the purchase price. That means if the stock hits this price, the position sells out and you walk away with a loss. On the other hand, if the stock goes up between 20 to 25 percent, you will sell it.
Let’s suppose you buy 100 shares of company “A” that costs $20 each. You will pay $2,000 in total for these shares.
Due to unforeseen market conditions, the price of the share goes down by 7 percent i.e. $18.60.
If you sell these shares, you now have $1860 left to trade.
Now let’s suppose you decide to buy 100 shares of Company “B” at $18.60 per stock. Your total will be $1,860. The ups and downs in the market make its price go down by 7 percent i.e. $17.30.
If you sell these shares, you will have $1,730 left to trade.
For your next move, you decide to buy 100 shares of Company “C” that costs $17.30 per stock. Your total will be $1,730.
Suppose the share price goes up by 20 percent. That means now each share costs $20.76.
If you sell these shares, you will have $2,076 which means you are taking home some profit.
Note: The figures have been rounded to make things simple.
Stick To The Plan
Setting up a profit vs loss ratio is easy but the real problem is sticking to it. This ratio is there to help you maximize profits and minimize losses. Sell only when the share price reaches 20 to 25%. If you want to ride the wave, you can always move our stop order after you reach your target price and take home more gains.
Experienced traders understand this well that setting a profit vs loss ratio on your trading software doesn’t always guarantee profitability. It’s, in fact, overly simplistic because it does not take into account the market’s realities. Therefore, it’s never recommended to solely rely on it for making profits.