A profit/loss ratio is a measure of the ability of a particular trading system to generate profit instead of loss.
A system’s profit/loss ratio is calculated by taking the average profit from all winning trades divided by the average losses on all losing trades over an arbitrary period of time.
Many novice investors appreciate the profit/loss ratio measure for this simplicity, since it makes sense that an investor wants their potential gains to be as large as possible and their potential losses to be as small as possible.
However, this is not always the case, and it can be a misleadingly simple approach that can actually do more harm than good if not used within a larger context of measures and indicators.
The blanket approach of setting out for a profit/loss ratio of 2:1 or more for each trade is simplistic because it does not account for the practical realities of trading in the markets, differences among trading styles and the average profitability per trade (APPT).
Average profitability per trade describes the average amount that an investor expects to win or lose for each trade.
Novice investors will be so focused on meeting some arbitrary profit/loss ratio that they will fail to realize the simple fact that the profitability of a trading system actually depends on its average profitability per trade.
The profit/loss ratio fails to account for the relative number of wins to losses, which means that an investor can have a 2:1 or even 3:1 profit to loss ratio while having a negative average profitability per trade.
How Profit/Loss Ratio Works
This measure offers an image of a trading system’s performance. The higher the number, the better the system is at predicting future price movements. Many investing books suggest a minimum of a 2:1 profit/loss ratio.
As an example, a system with a win average of $800 and a loss average of 400$ over a defined time period would have a profit/loss ratio of 2:1.
So if you had made $10,000 in profits for a month but had $6,000 in losses then you would have a profit/loss ratio of 1.6, which means you are losing on average more than half of what you are making on your winners.