A lot of traders throw around terms like “risk-reward ratio” and “profit factor” like they’re interchangeable, but they’re not. Understanding the distinction is key to evaluating a strategy’s true performance and managing expectations — especially during inevitable drawdowns.
Risk-Reward vs. Profit Factor
The risk-reward ratio measures how much a trade stands to gain versus how much is at risk. If you’re risking $100 to make $600, your risk-reward ratio is 1:6. Sounds great, right?
But that number alone doesn’t tell the whole story.
Profit factor, on the other hand, is a broader measure of a strategy’s overall performance. It’s calculated by dividing the total profits by the total losses over a given period.
A profit factor of 4.8, for example, means that for every $1 lost, the strategy has historically made $4.80.
Profit factor is the better gauge.
A high risk-reward ratio doesn’t guarantee consistent success. If you’re only winning 20% of the time with a 1:6 risk-reward, you’re still losing money. That’s where profit factor comes in — it accounts for both risk-reward and win rate.
In my Gamma Pockets strategy, the profit factor had been around 5.6 to 5.7, but after a recent drawdown, it’s at 4.5.
Does that mean the strategy is broken? No.
Every strategy experiences periods of lower performance. What matters is the long-term edge, and anything above a profit factor of 2 is strong.
Navigating Drawdowns Without Panic
Drawdowns and losses happen in every trading plan, and they’re normal — even expected. The key is knowing whether a decline is a temporary fluctuation or a sign of fundamental failure.
In the case of a fundamental failure, you have to make strategic adjustments to optimize performance.
The takeaway here is that traders should focus less on isolated losing trades or short-term setbacks and more on whether the strategy is structurally sound. That’s what profit factor helps determine.
If you only look at risk-reward, you might think every trade should be a big winner.
But the reality is, even with a strong system, losses happen. What matters is maintaining an edge over time — because in trading, longevity is the real game.
Keep your emotions in check, and it will serve you well.
Kane Shieh
Kane Shieh Trading
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*This is for informational and educational purposes only. There is inherent risk in trading, so trade at your own risk.
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