When talking about trading, the first thing that comes to mind is the entry and exit prices, the system's winning rate, and the rate of return, and the profit and loss ratio may be the next thing that comes to mind.
The profit and loss ratio plays a very important role in trading, which may be overlooked by most people.
In our daily transactions, many problems may seem simple or self-evident, but if you look at them from another angle, you will find the mystery.
Today we will share some "profit and loss ratio thinking" in transactions. After reading it carefully, you will definitely refresh your cognition and gain a lot.
First level: price and value
Price is the most direct factor in a transaction and the first thing that ordinary traders pay attention to. Regardless of whether they choose to short or long, the high or low price is the key to entry and exit for them. They will spend more time looking for the highs and lows of the market or guessing the market.
Compared with the high or low price, professional investors pay more attention to the value that the profit and loss ratio brings to the transaction. In other words, under the same risk conditions, how to bring a greater return on investment?
For example, there are two common ways to short sell. One is to predict that the market will fall during an upward trend and choose to short sell, as shown at point A in the figure. The other is to short sell during a breakout transaction, as shown at point B in the figure.
From a price perspective, short selling during the rising process can obtain a higher and more advantageous price. Short selling after a breakout is to enter the market after the trend is formed, and the price obtained is lower, which does not have much advantage.
But from a value perspective, although the price of shorting in a breakout transaction is relatively low, the rewards obtained are higher.
Why?
If we use the "profit and loss ratio thinking" to look at it, we can see from the figure that for the same target profit position, point A is assuming that the stop loss is at the highest point, the corresponding profit and loss ratio is 3.45, and point B is assuming that the stop loss is at the previous high point, and the corresponding profit and loss ratio is 5.93. Obviously, the profit and loss ratio of B is greater than that of A. In other words, we invest the same risk of $500, but the profit that can be obtained at point B is greater.
This is what we combine with the "profit and loss ratio thinking". From the value perspective, although point B has no price advantage, its risk-reward ratio is higher!
Moreover, when the market is rising, it is uncertain when the market will turn around. If the stop loss is not set appropriately, it will lead to a large loss. If it is too small, the stop loss will occur prematurely, and if it is too large, the risk reward will be too small.
When the market falls and breaks through, the market trend is basically stable. At this time, short selling can better manage funds and risks.
The second level: Win rate and profit expectations
Usually in trading, a trading system with a high winning rate is considered to be a necessary condition for making money, so a large number of novice traders are blindly pursuing a high winning rate.
If you think so, you are totally wrong!
Win rate is only one factor that affects the expected value of the profit of the trading system. In addition to the win rate, we also need to consider some other important factors.
First you need to understand a formula, this formula is called the profit expectation formula
Profit expectation = (win rate/50%) * profit and loss ratio - 1
When the profit expectation is greater than 1, the trading system can generate sustainable profits.
From the above formula, we can see that the mathematical expectation of the system, that is, the profit expectation is determined by the winning rate and the profit and loss ratio.
Let's take tossing a coin as an example. If you toss heads, you will earn 1 yuan and if you flip tails, you will lose 1 yuan. Then the winning rate is 50% and the profit-loss ratio is 1. Substituting it into the formula, the profit expectation is 0. In other words, this gameplay will not work as long as you keep playing. A win-lose outcome.
Let’s switch to actual transaction cases.
Assuming trading system A has a win rate of 80% and a profit-loss ratio of 1.5, the expected profit is calculated to be 2.4
Assuming trading system B, with a win rate of 30% and a profit-loss ratio of 4, the expected profit is calculated to be 2.4
From the structure of the formula, it can be seen that high win rate and low profit and loss ratio A = low win rate and high profit and loss ratio B. Both systems can make profits and the profit expectations are the same.
So don’t focus too much on a high winning rate. If you can’t achieve a high winning rate, just optimize your profit and loss ratio to the limit. Like Buffett, if a stock can make tens or hundreds of times the profit, then even if the winning rate is low, he will eventually make a profit.
The third level: system optimization
Speaking of profit expectations, we have to talk about the trading system. From the above formula, we can also find that: for a trading system (strategy) to be able to make continuous profits, first of all, its profit expectation must be greater than 1, and the higher the better.
Profit expectation = (win rate/50%) * profit and loss ratio - 1
When most novice traders consider optimizing the system, the first thing they think of is still to improve the winning rate, rather than optimizing other factors. It can be said that "a system with a high winning rate is a good system" has become the habit and potential understanding of most ordinary traders.
But this is a perceptual understanding, and emotional factors outweigh rational factors. The trading market is an objective world, not subject to subjective influences. Trading decisions need to be made after careful and rational thinking.
When optimizing a system, appropriate optimization should be taken for each indicator of the system. Over-optimization of a certain indicator will not bring significant growth to the overall benefits, but will also consume a lot of resources.
Suppose you are optimizing a primary system. A slight optimization will make a clear difference. When the system is more complete, the space that needs optimization will be reduced.
If you try to improve your win rate at this point, it won't bring you significant profits, and it will be difficult to improve your win rate. Optimizing your win rate is like improving your grades in a single subject. It's easier to improve from failing to 60 points, and when your grades reach 80 points, if you continue to improve, you'll reach another level.
At this time, you can improve the grades of other subjects to increase the total score. When optimizing the system, you should increase the profit and loss ratio. For example, the system's winning rate is already very high, reaching 70%. At this time, it will be easier to increase the profit and loss space and improve the profit and loss ratio.
Level 4: Save time
Generally speaking, a trading system with a high profit-loss ratio is run by the market itself, allowing the funds to grow on their own. Compared with a high-win rate system, there are fewer trading opportunities, but its potential returns are higher.
When traders focus on finding trading opportunities with a high profit-loss ratio, they will enter the market more cautiously and conduct more in-depth research and analysis on the products to ensure that each transaction has a higher probability and potential return.
In contrast, if traders focus only on high win rates, they may be attracted to frequent low-profit trades, leading to excessive trading activity and time consumption.
In terms of time management, traders who focus on high win-loss ratios have more time to devote to high-potential trades, thereby greatly improving trading efficiency and freeing up their own time.
Of course, the profit and loss ratio plays an important role in trading, but it does not mean that we only need to focus on it. It is just that in many ways, it will be more convenient for us to use the "profit and loss ratio thinking" to solve problems, and it can also bring more profits.
Of course, during the trading process, the profit and loss ratio thinking can solve problems at many levels, not just the above four.
In the process of trading, what trading problems have you solved using the profit and loss ratio thinking? Welcome to leave us a message to discuss!
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