There are so many trading metrics out there that it is hard to understand them all. Yet as we have shown in this article some of them are very important and can help you to analyze and improve your trading performance. Today we are going to look at the payoff ratio. It’s a little bit less known, but does this mean it’s a hidden gem? In this article, I will try to explain what the payoff ratio is, how to calculate it, and if it's useful.
What is payoff ratio?
The payoff ratio is defined as the average winner per trade divided by the average loser per trade for a trading system. The higher the payoff ratio the better the trading system performs.
So, in other words, it’s a will tell us if our average winner is bigger than our average loser (or not). It sounds pretty simple and it indeed is very simple. Let's take a look at how to calculate it.
How to calculate the payoff ratio?
To calculate the payoff ratio, we need to know our average winner and average loser per trade.
Luckily these are easy to calculate.
Our average winner is just the total profit made divided by the number of winning trades and our average loser is the total money lost divided by the number of losing trades. This means the complete formula to calculate the payoff ratio is:
Let’s assume a trader which
- Made a total profit of $4000 profit with 30 winning trades
- Lost a total of $2000 with 20 losing trades
Then his payoff ratio will be:
In general, a payoff ratio of 0.8 is considered good, although we must warn you that this greatly depends on your win rate. In the next paragraphs, we will show you why.
What is the difference between the Payoff ratio and the Profit Factor?
Some people confuse the payoff ratio with profit factor and since they are both a ratio using similar metrics that’s understandable.
There is however a big difference between the 2.
The profit factor is the gross profit of a trading system divided by the gross loss of a trading system. Simply put. it’s the total amount of money you win divided by the total amount of money you lost. The payoff ratio, however, is the average winner per trade divided by the average loser per trade as explained in the previous paragraph. So, where the profit factor is looking at the overall performance of a trading system including all the trades, the payoff ratio looks at the average performance of a trade
To recap here are the formulas for both payoff ratio and profit factor.
Which is more useful? the payoff ratio or the profit factor?
Generally speaking, the profit factor will tell you more about how a trading system performs then the payoff ratio. The reason for this is that the payoff ratio fails to take your win rate into account. It sure sounds like you are doing well if your average winner is greater than your average loser but without knowing your win rate this won’t tell you if your system is profitable. The profit factor, however, looks at the total wins and losses made, and while there may be better methods out there, it at least will tell you If your trading system is profitable or not. A profit factor above 1 means your trading system is profitable and a profit factor below 1 means your trading system is losing. The payoff ratio, however, cannot tell you this just by itself.
Consider the following two trading systems:
| ||Average winner||Average loser||Payoff ratio|
Note that system B has a payoff ratio of 1.5, while system A has a payoff ratio of just 0.333. Surely this must mean System B is much better right? The answer, however, is that it depends on your win rate. Without knowing the win rate its impossible to say which system is performing better. So, let’s add the win rate to the mix.
| ||Average winner||Average loser||Payoff ratio||WinRate|
Now we have included the win rate we can calculate the gross profit and loss which we need to calculate the profit factor
System A Total profit: 90% * $300 = $243
System A Total loss: 10% * $900 = $90
And thus, the profit factor is $243 / $30 = 2.7
If we do the same for system B we get:
System B Total profit: 30% * $300 = $90
System B: Total loss:70% * $200 = $140
And thus, the profit factor of is $90 / $140 = 0.64
Now we clearly see that system A is performing much better than system B, even though System A has a payoff ratio of just 0.333
So, in conclusion, the payoff ratio by itself is not really usable without knowing your win rate. You are better of knowing your profit factor, win rate, and expectation / expected value. We explained all of these here in case you want to know more about them.
Should you use the payoff ratio to analyze your trading?
As shown above I personally don’t see any reason to monitor and analyze your payoff ratio. The profit factor together with other metrics like win rate, expected value, and others will give you many more insights into your trading performance. So, if your trading journal or spreadsheet includes the payoff ratio then just ignore it and focus on the more important metrics. Sometimes less is more and that is surely the case here. That is also the reason we did not include the payoff ratio in our own improve your trade journal 😉
Note that of course, this is just my opinion if you have found a good reason to use the payoff ratio then, by all means, use it. And perhaps send me an e-mail about why you think it’s useful after all!