Below we introduce some initial basic terms from Risk Management.
Hit Rate is a measure of the ratio of the number of winning (profitable) trades over a set period of time, divided by the total number of trades.
Hit Rate = number of winning (profitable) trades / total number of trades
Example: A trader enters 20 trades over a one month period (approximately one trade a day) and 13 of these trades were profitable and 7 were losses.
The Hit Rate would be:
Hit Rate = 13 / 20 = 0.65 or 65%
Calculated before a trade is entered, this is the ratio of the potential rewards (profits) of a trade compared to the potential risk (losses) accepted to attain these rewards. This is calculated by dividing the amount of potential or projected profit by the amount of potential loss.
Reward-To-Risk Ratio = potential profit / potential risk losses
Example: A trader looks to enter a trade to go Long (to Buy) at $100. The target on the trade to take profit is at $120. The Stop Loss on the trade is going to be placed at $90.
So, the Reward-To-Risk Ratio would be:
Reward-To-Risk Ratio = $120-$100 / $100-$90
= $20 / $10
= 2/1 or 2:1