Win / Loss Ratio in CFD Trading

Among the questions often asked by clients when selecting an adviser or a system for CFD trading is what percentage of recommendations they can expect to be winners, and how much should they expect to make each month, year or whatever. These form part of a natural psychological comfort zone, but may be part of the reason why so many people fail as traders.

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In any area of speculation, whether it is stockmarket investment, spreadbetting, forex trading or CFDs, if the underlying system has a small edge, it is only the first part of potential success. The key to achieving constant returns lies with a correct approach to the win/loss ratio and not in expecting any particular level of gains, which can distort the underlying methodology. CFD traders have the ability to go long and short at will, and online trading makes it easy to adjust stops and targets at any time.

An example of a good win/loss ratio that fails
Consider this example: a CFD trader selects a system where there is a supposedly proven record of seven out of each ten trades proving to be winners. The idea might be that each trade has a target return of 3%, and if it is achieved the position is closed. If the trade however shows a loss of 3%, the expectation is that it should recover and the position is doubled up, with the hope of returning to parity or even making a 6% gain. Now if market or share movements were a random sequence, it would not make any difference where one entered or exited. The overall returns would over time be neither a gain nor a loss, but costs and the spread on trading would result in a virtual guaranteed loss in due course (the casino approach).

Having a slight edge is not enough
If this system had an edge though, the expectation might be that the 3% target would possibly be hit six out of ten times, thus making it a virtual winning approach. But the problem lies in the fact that although markets and shares do have short term periods when there appears to be random action, they can both trade a range and trend strongly at other times – this is what is known as regular irregularity, which might seem a paradox, but happens all the time in financial markets.  Shares often move very quickly in one direction, and this trend can continue for far longer than expected, which creates two problems.

First, taking a 3% profit on a trade may appear to be very satisfactory, but it can often be seen in hindsight that the profit was taken too early, so despite achieving a winning trade there is an element of regret that more was not taken. Second, if the position is showing a loss, then the trade should in the real world be deemed to be incorrect and closed out. But in using such a system as this, by doubling up or averaging the position on losses, all that is achieved is an increase in risk – the trader might be lucky in some situations, but one or two trades out of the ten may cause severe problems. There is also the emotional capital that is tied up in losing trades.

This type of system typically might produce say six 3% winners, two evens (where one position was doubled up and returned to parity) and two 10% losers. Here the overall loss would be 2%, despite the good win/loss ratio, and this is clearly a dangerous way to play the markets, but many traders operate exactly in that way.

Improving the risk/reward
The first point is to set a stop loss on each trade and stick to it. Doubling up simply doubles the risk – that is fine if there is another system signal that reinforces the first trade, but generally that is not the case. The problem that then occurs is that if the stop and targets are quite close in percentage terms, the bouts of short term randomness mean that it can almost be like coin tossing, which with costs is a futile approach.

The key is therefore to ensure the gains are much greater than the losses, so that even if one only achieves four wins out of ten, there may be two big winners in there. If a trader decides that a 3% average loss is acceptable, then what average gain should be sought? This is the $64 question, and the key is to let profits runs as much as possible within a clearly defined trend. The following rules are part of the methodology used at Blue Index for the longs and shorts CFD portfolio, and the long term results have so far proved more than satisfactory.

Some simple rules for a consistent winning approach

• If searching for stock trades, try to choose high volatility or beta shares – these have a higher chance of being in a trend rather than trading a range or exhibiting random action.
• The expected initial target should always be at least twice the stop loss. If the average stop loss set is 3%, the CFD trader should look for 6%-plus gains on each trade as a starting point.
• Try to set individual stops and limits with reference to the underlying action. If a share has moved 10% one day, it is likely to exhibit an intra-day range of much more than 3%, so the stop and target should be widened accordingly. Also support and resistance levels are very useful reference points for setting price targets.
• If the trade hits the initial target, either close the position if support or resistance around that area is seen to be valid, or move the stop up to protect profits and let the position run.
  5. If there is a sudden reversal in share price trend, close the position, whether it is winning or losing.  The swings and roundabouts of trading usually mean that these unexpected trend changes even themselves out.
• Make sure you are never exposed too much in one direction. If for instance the market falls heavily from the open, then it doesn’t matter, as even if there are more longs and shorts in your list of open positions, the huge gains on the shorts should outweigh the stops hit on the longs.

Target returns
As for target returns, many traders have unrealistic expectations. A system that can offer huge returns inherently has to have a higher risk, but bear in mind this simple fact. Warren Buffett has achieved just over 20% per annum returns on his investment fund, and he did not need to use leverage to become the world’s second wealthiest man.

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What are Key Investment Ratios?

One aspect of smart investing is being able to determine whether or not a company is a healthy company in general and not just this past year. You also want to know if a stock is really a bargain or not. Stock price and dividends are good to know, but not the only pieces of information you need to make sound, long-term investment decisions. A good year of either doesn’t mean there will be more.

Magic Numbers: The 33 Key Ratios That Every Investor Should Know by Peter Temple Provides a straightforward primer to calculating and interpreting 33 key investment ratios. The book is organized into five sections that explain market-based ratios (e.g., market capitalization, P/E ratios), income statement ratios (margins, earnings per share), balance sheet rations (price/cash ratio, burn rate), cash flow ratios, and risk and volatility ratios. Each chapter clearly shows the inputs necessary to calculate a particular ratio and explains its relevance in evaluating a company's performance.

When making a decision about where to put their money, savvy investors use ratio analysis. There are three kinds of ratio analysis:

• Profitability Ratios: measure how much profit a company generates
• Gearing Ratios: assess a company’s leverage
• Liquidity Ratios: measure the ability of a company to meet its debts
• Investment Ratios: measure the performance of the overall business.

This article focuses on investment ratios. There are countless ratios you can know about, but those referred to as the key investment ratios are the ones that will help the basic investor get the information they need to make a sound decision. The good thing is that most of the information you need to do these ratio’s calculations can be found in the financial statement, annual report or balance sheet of the company whose stock you’re investigating.

P/E Ratio is the ratio most people are familiar with and helps one determine whether or not a stock is too expensive or a really good deal by looking at the earnings relative to stock price. You divide the current stock price by the last four quarter’s earnings. If your company’s stock is trading at $20 a share with a .50cent EPS (earnings per share), your P/E Ratio is 40. A low P/E ratio means the company is undervalued and the stock is probably a good deal. If the P/E ratio is too high, the company is overvalued and you probably don’t want to pay more for a stock than its worth.

Return On Equity is a simple calculation that allows an investor to look into the profitability, asset management and financial leverage of a company. A company’s ability to maintain good levels within these groups signify a good investment for many. For ROE, you divide a year’s worth of earnings by the average shareholder’s equity (found on the company balance sheet) for that same year.

Earnings per share (EPS) is the most basic ratio and probably the simplest. You divide the number of average shares outstanding by net income minus the dividends on preferred stock. So, if a company’s post-tax profits are $1.2 million and there are 20 million shares issued, the EPS is .06. You’re looking for smooth, consistent growth here.

Dividend Payout Ratio calculates the percentage of earnings paid to shareholders by dividing earnings per share by yearly dividends per share or dividing net income by dividends. More mature companies have a higher payout ratio and if you’re looking to use dividend payments as income, this is important.

P/E Growth Ratio is used to determine a stock’s value while considering earnings growth. You divide annual EPS growth by the P/E ratio. A lot of managers prefer this to the P/E ratio because of the growth component.

Net Asset Value (NAV) is a ratio for mutual funds and equals the total value of the fund’s portfolio less liabilities. You’ll get this dollar amount by dividing the current market value of a fund’s net assets by the number of shares outstanding. So, if your fund has net assets of $100 million and there are one million shares in the fund, the NAV is $100.

Return On Investment (ROI) is what a company does with assets to generate additional value for shareholders. It is a percentage ratio calculated as net profit divided by net worth. It is also defined as a measure of a corporation’s profitability. If a $100 stock returns $15 a year, your ROI is 15%. Obviously, you want this percentage to be as high as possible.

Profit Margin is a calculation that fits into investment ratios as a key indicator of profitability. Usually displayed as a percentage, profit margin is calculated as net earnings after taxes divided by revenues and is useful when you want to compare stocks within a particular industry to those in similar industries. As you’ve guessed, a higher margin indicates a more profitable company.

Turnover Ratio is a measure of the number of times a company's inventory is replaced during a given time period. Turnover ratio is calculated as cost of goods sold divided by average inventory during the time period. A high turnover ratio is a sign that the company is producing and selling its goods or services very quickly.

Leverage Ratio (also referred to as Debt To Equity Ratio) is found by dividing the company’s total amount of long-term debt (debts with interest rates that have a maturity longer than one year) by the total amount of equity. A company is likely able to make its interest payments on debt regardless of a moderate sales decline if their leverage ratio is under 50 percent. A company with a higher leverage ratio can offer greater returns to shareholders but can also be riskier.

Dividend Yield is a percentage ratio of a company’s annual cash dividends divided by its current stock price. To get your annual cash dividend, you multiply the next expected quarterly dividend by four. If a $100 stock pays $2.50 quarterly, then your annual cash dividend is $10. Divide this by $100 and you get your dividend yield: 10%.

Market Capitalization, the current market value of a company’s outstanding shares, can be found by multiplying the number of outstanding shares by the current price of each share. A company with 1 million shares outstanding, trading at $75 per share, has a market cap of $75 million.

Current Ratio can be calculated by dividing current assets by current liabilities. You would use this ratio to see if the company can pay their current debts without going against future earnings. You’ll want to see a ratio of 1 or higher here.

Price To Book Value Ratio is calculated by dividing the current price of a stock by the book value. Book value, an accounting term, is the net asset value of a company. Whether the ratio is high or low could be a result of a company being old or a new start up with stock that hasn’t yet depreciated. It’s not a tell-all ratio, but does help in your overall research.

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