Winners vs Losers: a matter of perspective

From Innerworth

To change one's life: 1. Start immediately, 2. Do it flamboyantly, 3. No exceptions.

- William James -

We all want to feel like winners. Winning makes us feel on top of the world, as if we can do anything. But in the trading business, the bottom line is how much money you make in the end. As we discussed in a column earlier this week, the best way to monitor your performance is to use a win-loss ratio, but there are many different ways to calculate this statistic, and each have advantages and disadvantages.

The first issue to consider when calculating a win-loss ratio is to decide on a reference point to use for your calculation. It's up to you, and it depends on how many trades you make. If you only make 10 trades a year, it makes sense to use a year as your reference point. If you make 10 trades a day, in contrast, you may want to use a day as a reference point. Most people would probably use a week or a month. Specifically, the win-loss ratio would be based on all trades made in the reference point. For example, if you decided to use a month as your reference point, you would calculate the win-loss ratio based on all the trades you made in a month.

The second issue is to decide which formula to use to calculate the win-loss ratio. There are at least three ways. In the first way, traders compare the number of winning trades to the number of losing trades. The dollar amounts are ignored. For example, if you made 10 trades in a week, and 6 trades were winners and 4 trades were losers, you would divide winners (6 trades) by losers (4 trades), and end up with a value of 1.5. Values greater than 1 indicate that you are winning overall (based on a reference point of a week), whereas values less than 1 indicate that you are losing overall. Some trading experts criticize this approach because it is easy to distort this statistic. If you know, for example, that you have made 5 losers and 5 winners, you can make a few small winning trades that produced relatively little profits and make yourself come out as a winner. It is argued that because the dollar amount is not built into the ratio. it provides a biased picture. Perhaps this is true at times, but not always. If you make a fair number of trades, such as 100 trades during the reference point, a few winners or losers here and there will not impact the win-loss ratio very much.

A more formal approach, which is often used in the money management strategy developed by John Kelly, uses the average dollars won and lost across a series of trades in a reference point, such as a month. For example, if you made 20 winning trades and 80 losing trades in a month, you would calculate the mean dollars won across the 20 winning trades and the mean dollars lost across the 80 losing trades. Once you have the two averages, you would simply divide the average dollars won by the average dollars lost. Again, values greater than 1 indicate that you are winning overall, whereas values less than 1 indicate that you are losing overall (across the reference point). The advantage of this approach is that the actual dollars won or lost are taken into account. The disadvantage is that an average, or mean, may not provide an accurate view of how much money is won or lost. For example, one can make merely two winning trades, and have an average win of $100, and make 40 losing trades with an average loss of $50, and obtain a win-loss ratio of 2. Theoretically, however, you could have won $200 on the two winning trades and lost $2000 on the 40 losing trades, which would be a substantial overall loss of $1800, a figure completely opposite to the win-loss ratio of 2. This is merely a hypothetical example, and probably would rarely occur, but you can see the point. A win-loss ratio based on average dollars lost and won may distort the picture.

The disadvantages of these two approaches have led us at Innerworth to suggest using a modified version of the win-loss ratio. We suggest taking the total amount of money you won across a series of trades and divide it by the total amount you lost. For example, if you made 20 winning trades and won a total of $5000, and made 15 losing trades and lost a total of $4000, you would divide your wins by losses and end up with a value of 1.25. (It may also be useful to multiply this value by 100 to remove the decimal).

There is no one right way to trade, and there is no single correct way to calculate the win-loss ratio, but whatever you decide, it is useful to monitor your performance. By calculating a win-loss ratio, you remove some of the mystery and uncertainty in trading. You know where you stand, and you will be more aware of where you have been and can think more clearly about where you are going.