Strategic Investing, How to Setup a Profit vs Loss Ratio

A profit vs loss ratio is something that can by itself help you succeed investing in the stock market. They work wonders for new traders, and are used by professionals as well.

This article will explain what a profit vs loss ratio is, how to set one up, and how to stay disciplined to utilize it effectively.

What They Are

A profit vs loss ratio is a plan that you put in place to limit your downside exposure on all your trades to x%, while setting a target on your upside to x% return per trade. Depending on how you setup your ratio, you can be wrong more than you are right and still make money in your portfolio.

The whole point of your profit vs loss ratio is to be able to say, “hey, even if I am wrong x times in a row and then am right once, I still am making money”.

How to Setup Your Ratio

There are 2 factors to any ratio: maximum loss % per trade, and your target profit % per trade. Once you know these you know your ratio.

The best ratio and one that is recommended by CANSLIM founder William O’Neil ( read his books) is to utilize a 3 to 1 profit vs. loss ratio. This means that we can be wrong twice, then be right once, and still make a profit.

So, let’s use the CANSLIM philosophy and say that we want to cut our losses to a maximum of 7 or 8 percent each trade. To do this, when we buy our position we immediately place a stop loss order 7 or 8% below our purchase price. If the stock hits this price, the position is sold out and we walk away with our loss. On the upside we will sell any stock after it is up between 20 – 25 %.

Let’s see how a few trades would play out (numbers are rounded for simplicity):

Trade 1
You buy 100 shares of a $20 stock, so $2000 total…
but it goes down 7% (-$140)…
to $18.60, and you sell leaving you now $1860 left to trade.

Trade 2
You buy 100 shares of a $18.60 stock, so $1860 total…
but it too goes down 7% (-$130)…
to $17.30, and you sell leaving you now $1730 left to trade.

Trade 3
You buy 100 shares of a $17.30 stock, so $1730 total…
and it goes up 20% (+$346)…
to $20.76, and you sell leaving you with $2076 total.

Even though you lost twice in a row, you still made money overall in your portfolio. With a 3 to 1 profit vs. loss ratio we in a sense have a .333 batting average and still are successful traders.

Maintaining Your Plan

This is the most important part. So, let’s say you want to implement the CANSLIM 3 to 1 profit vs loss ratio, you have to write it down and STICK WITH IT.

How do you do this? You use stop loss orders to always minimize your losses, and you ALWAYS sell 20 – 25% above your purchase price. If you want your runner to run longer, then once you are up to your target price move your stop order up to lock in your gains.

The bottom line

It is a fact that some of the best traders in the world are only right in the stock market less than half the time. By staying disciplined and using a good profit vs loss ratio though they still make money consistently in the stock market. Great traders know how to strategically invest, they use a profit vs loss ratio.

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Comments

  1. Mikel says

    You can set Yahoo alerts to automatically alert you when your stick goes above/below a % that you define. it’s handy and quite simple.

  2. says

    This is definitely an important exercise for any trader to participate in. Whether you hold positions for hours, days, months, or years; reviewing trades, win/loss percentages, and profit/loss ratios will yield valuable insights in skills and deficiencies within your trading style.

    As always, application is the key – take the information and PUT IT TO WORK!

    Thanks for such a thoughtful piece.

    Zach

  3. says

    There is a quote (I forgot by who) that perfectly sums up to this strategy. It goes something like:

    “90% of all my profits came from 10% of my trades”

    I’m more of an investor than a trader, so I’ve never really put the strategy you’ve written about into action, but it sounds like a good foundation for trading.

  4. Frank Lindholm says

    Blain,

    Could you give me your professional

    opinion of the one-lot performance

    statistics of my best strategy that I

    developed for trading the S&P Emini

    futures on 30 minute bars over a 4 month

    period?

    Net Profit: $16,700.00
    Return on Capital: 167%
    Gross Profit: $17,500
    Profit/Loss Ratio: 21.88
    % Profitable Trades: 96.55%
    % Losing Trades: 3.45%
    Largest Profitable Trade: $950.00
    Largest Losing Trade: -$800.00
    Average Profitable Trade: $625.00
    Average Losing Trade: -$800.00
    Average Trade: $575.86
    Max Consecutive Profitable Trades: 18
    Max Consecutive Losing Trades: 1
    Initial Capital: $10,000.00
    Final Capital: $26,700.00
    Gain to Pain Ratio: 16506.92
    Sharpe Ratio: 424.21

    Thank you!

  5. says

    Hi Frank,

    Unfortunately to do not trade e-mini futures. I am sorry. Your best bet is probably to post this on a stock forum message board that has futures traders on it. Try elitetrader.com for example.

Trackbacks

  1. [...] Use stop loss orders. Stop loss orders are like insurance, they are stock orders that will automatically sell your position at a pre-determined price if that price is hit anytime during the trading day. They remove the “do I sell now? Should I hold instead?” drama of investing and replace it with a disciplined strategy. They are also perfect for maintaining a strong profit vs loss ratio. [...]