ROI stands for “Return On Investment“, which means return on investment. ROI is a relative value since it always expresses the return or economic result produced by a given investment in relation to that investment. Because it is a relative performance indicator, ROI is usually expressed as a percentage.
Sometimes ROI is also referred to as “yield“, “profit ratio” or simply “return”. All these terms refer to the same concept: the relationship between a certain amount of capital invested and the result that this investment has had on the investor.
Before we go, we’d like to inform you that all information provided only for educational purpose. These are not any financial advice.
How to calculate the ROI in Trading?
In trading the ROI: is the relationship between the money earned, or lost, and the amount of money that has been allocated to operate.
To calculate the ROI in trading, the following formula is used:
ROI = (Profit – Trading costs) / Capital employed in trading.
This formula expresses the trader’s net profit (profits-costs) divided by the capital he has used in his operations. The ROI can be calculated over a single time period or as the average between different time periods. This means that one can calculate the ROI of a single trade or calculate the ROI of a given trading period as a whole:
- In the first case, if one invests in a trade $100 USD and when he closes the position, he gets in his account $115 USD back, the ROI of such a trade would be 15%. = (15/100).
- Regarding the second case, for example, if at the beginning of a month the trading account of an expert trader has a balance of $1,000 USD and, at the end of that month, the balance in his account is $1,100 USD, then the monthly ROI of that trader would be equal to 10% = (100/1,000).
As can be seen in the examples, to calculate the ROI, the net economic result of trading is always taken into consideration, i.e. the profit of the operations that is recorded in the trader’s account, after deducting all the costs of trading activity such as spreads, swaps, or interest.
How useful is the ROI in Trading?
ROI is one of the most used indicators to measure the performance of trading activity. It is usually used in three ways:
- To define objectives.
- To compare traders.
- To compare trading strategies.
To define objectives
To operate in the markets in an efficient way it is essential to have previously defined profitability objectives. Trading is an activity that combines the use of different analysis techniques with risk management. For trading to be efficient, the risks assumed must be compared with the expected profitability.
Before opening a trade, the trader must be very clear about the reasons for opening such position (analysis) and the capital of his account that he will put at risk in it (and capital), as well as the objective profitability of such position (ROI).
The capital that the trader will put at risk in each operation and the number of operations that he will develop in a period will be defined by the objective of profitability that has been previously set.
This relationship is explained below with an example:
A trader has invested $10,000 USD in his trading account and set a monthly ROI target of 2%. If he meets this target at the end of the year, his account could have grown by 24%.
With this target ROI the trader’s monthly profit would have to be at least $200 USD.
As a risk management strategy, he decides to risk only 1% of his account on each trade. In his case, he would risk $100 USD on each trade.
Taking this into consideration, if he chooses to make trades with a risk/reward ratio of 1/1, he should make at least two trades per month to meet his goal.
This is because since the risk/reward ratio is 1/1 the expected profit on each trade is precisely equal to the capital being put at risk: $100 USD. As the monthly target profit is $200 USD, the minimum number of operations to reach that amount is two.
As you have seen in the example, ROI, risk and trade analysis are closely related in any trading strategy. If instead of opting for trades with a risk/reward of 1/1, the trader opted for trades with a higher reward, the minimum number of trades would change. But in any case, whatever the development of the strategy, it would always be preceded by the previous definition of a target ROI.
Comparing the performance of different traders is not always easy, since many factors are involved that influence their activity, such as the size of the account they manage, the period in which the comparison is made, or the risk profile assumed.
However, one indicator that is always used when making such comparisons is ROI. With similar account and risk management profiles, a trader who obtains a higher ROI in each period of time will obviously have registered more efficient operations in terms of profit than another who in the same period has obtained a lower ROI.
The comparison can be made based on the ROI obtained in a given period of time or also as the average ROI calculated from the ROIs of each individual operation of each trader.
Comparing trading strategies
Another application of ROI as a profitability indicator is the evaluation of trading strategies. When a trader studies a certain trading strategy, one of the analyses he usually performs is to simulate the result he would have had in the past applying that strategy.
In this simulation, the trader seeks to calculate what would have been the ROI he would have obtained if he had applied the strategy in his trading. To perform this calculation, it is important to consider a sufficiently representative period, because if the analysis period is too short, the simulation may give unrepresentative ROI values, which may be too high or even too low.
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