Tuesday, April 3, 2012

Win/Loss Ratio and Winning Percentage: Benchmarks when Designing a Trading System

“You never change things by fighting the existing reality, to change something, build a new model that makes the existing model obsolete.” - Buckminster Fuller.

Having certain benchmarks to attain when designing a trading system are important because they help steer you in the right direction when you come to a sticking point in designing a profitable trading system.  Instead of saying “I want to earn $X per day” or not having a goal at all, focus on 3 important functions:

Win/Loss Ratio (W/L) = Avg Win/Avg Loss

Winning Percentage (WP) = No. Profitable Trades / Total Number of Trades

Expectancy = (Avg Win * WP) – (Avg Loss * (1 – WP)

These three factors can be used to construct the basis for a profitable trading system.

Assume for a second that you have $10,000 of initial capital to fund your account.  A general rule you hear is that you need a system with a W/L ratio of 2 (your average win is 2 times greater than your average loss) and a winning percentage of 40% (out of 100 trades, you will have 40 profitable trades and 60 un-profitable trades or losers).  If you take 400 trades using this system, what will your Expectancy and ending account balance be?

Expectancy = ((W/L + 1) * WP) – 1 = (( 2 + 1 ) * .4 ) - 1 = 0.2

After 400 trades, your account has grown to $18,000.

But what if you know your Win/Loss ratio and want to tweak your system’s Winning Percentage so that you have a positive Expectancy system?  The table below shows you the minimum Winning Percentage to have a positive Expectancy system (an Expectancy at least equal to 0).

Win/Loss Ratio
Min WP to Have Positive Expectancy
0.25
80.00%
0.5
66.67%
0.75
57.14%
1
50.00%
1.25
44.44%
1.5
40.00%
1.75
36.36%
2
33.33%
2.25
30.77%
2.5
28.57%
2.75
26.67%
3
25.00%

For example, if you have a W/L ratio equal to 2, your WP must be equal to 33.33% to have a positive expectancy system. 

The formula to find the minimum WP for a positive expectancy system is:

Min WP = 1 / (W/L + 1).

The Chart below breaks this formula down by some common W/L ratios:

This is a useful exercise because it can immediately identify the weakness in your system.  If your system isn’t performing, either increase your WP or your W/L ratio.  This can usually be achieved by changing your exits:  increasing the profit target or adjusting your trailing or indicator stop (like an ATR stop).  More on exits later.

Say you know your W/L ratio and want to determine the WP required to have a known Expectancy.  For example, assume you want a system with an Expectancy of 0.5 and you have a W/L ratio of 1.0 – what is the required WP?  You can use the chart below:

Looking at the red line, you see you need a WP of 75% to have an Expectancy of 0.5 for a system with a W/L ratio of 1.0.

Or you can use the formula above to solve for the required Expectancy.

Expectancy = ( ( W/L + 1) * WP ) – 1

0.5 = ( ( 1 + 1) * WP ) – 1

Solving for WP shows that you need a WP equal to 75%.

Keep ya mind right and happy trading.




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