The APPT: Better than a P/L Ratio in Gauging Success?
(eToro Blog) One strategy for money management suggests that the average profit for each individual trade should be more than average loss for each individual trade. On the face of it, that seems to be good advice but an analysis shows that the old profit/loss (P/L) relationship might need to be reconsidered.
If we look at the ratio with some numbers attached to it, it seems pretty simplistic and arguably a fairly sound strategy. Say for example on one particular trade your expected profit is $90 while your expected loss is $30 then the profit/loss ratio (which refers to the relationship between the average profit and the average loss) is 3:1, or $90 divided by $30. That’s a ratio advocated by quite a few experts, though some suggest a 2:1 ratio is also acceptable; of course it all depends on your personal risk threshold. It makes sense to keep your losses to a minimum, even as you try to maximize your profit potential. Or does it?
One consideration about the typical profit/loss ratio is that it is overly simplistic; that it fails to take into account some of the realities of the foreign exchange market, trading style, or the average profitability per trade factor or the statistical expectancy.
The Average Profitability per Trade or APPT is a reference to the average amount per trade that you might win or that you might lose and, in fact, your trading performance largely depends on it. The formula to calculate APPT is the probability of a win times the average win minus the probability of a loss times the average loss.
Some numbers make it easier to understand:
Out of 20 trades, let’s say you make a profit on six of them and take a loss on the others. Your probability of a win is 0.3 or 30% and your probability of a loss is 0.7 or 70%. Let’s also say that the P/L ratio is 2:1 and your average winning trade is $60, while your average loss is $30. Given the formula your APPT would be (negative) $-3.
(0.3 x $60) – (0.7 x $30) = – $3
That negative APPT means simply that you are apt to lose $3 for each and every trade! Though the P/L ratio was 2:1, the trading strategy only produces a winning trade 30% of the time.
What if we look at a 3:1 P/L ratio? Let’s say this time of the 20 trades, we win 16 of them and lose only 4. Your probability of a win is 80% and your probability of a loss is 20%. The APPT for that would be $2.
(0.8 x $10) – (0.2 x $30) = $2
As a positive number, the APPT suggests that your desired trading strategy has the potential to be profitable over time.
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