What Is Your Trading Expectancy?
Why you need to know your trading expectancy and how to calculate it?
The term “trading expectancy” is used to establish how much money you are expecting to make on every trade, on average, on a large enough size.
In other words, you will win and lose dozens of times within a 100-trade sample size. Depending on your win rate and your profit-to-loss ratio, you can extrapolate how much money every trade makes you. Winner or loser!
Expectancy = (average gain X win %) – (average loss X loss %)
Example:
Your win rate is 40%, which means you win on 40% of all trades and lose on 60%.
Your profit-to-loss ratio is 3 vs 1 (when you win you make 3R, when you lose you lose 1R).
If you risk 100 USD per trade, you make 300 USD and lose 100 USD on your trades, on average.
Expectancy = (300 USD X 0.40) – (100 USD x 0.60)
Your trading expectancy then is 70 USD per every trade you open, win or lose, on a large enough sample size.
From the point of view of the whole trading season, for example, every trade is then a winner. As you can’t get to all the winners within a system, without going through the losers. Out of 100 trades, most will be losers, 60 in the above example, and only 40 will be winners. But since your profit on winners is 3 times the size of your losers, things will take care of themselves over time. It’s all just a big old numbers game.
This particular number (trading expectancy), as far as I’m concerned, doesn’t really mean much. Except that it illustrates a very important point.
On a large enough sample size, the losers don’t matter as long as your system is profitable. It doesn’t matter if you win or lose this next trade or two.
There are infinite systems and trading approaches with an infinite combination of possible win rates and profit-to-loss ratios. You could be losing 90% of the trades you open and still make a lot of money if your winners are enormous compared to your losers. On the other side of the stick, if you have a very high win rate, meaning you win almost all of your trades, your winner can be much smaller in comparison, and you’ll be ending up on top.
So if you have a system where you lose 60% of the time, but your winners are at least 3 times the size of your losers, you’ll be positively printing money in the market. Even though you will lose 60 out of 100 trades, you will make money, lots of it!
Do not fear losing on your trades, but do contain those losses to a minimum!
Every trading system or trader statistic, if you will, will have losers and winners randomly distributed across a large sample size. There is no avoiding this. You must find a way to accept that fact and learn to accept the losses in your trading, giving them no extra thought, as long as the trades were executed in accordance with your proven system with an actual edge.
How do you know your system has an edge in the market?
Well, is it profitable over time? Backtest it and then backtest it some more. You need that data. Then trade it as much as you can and journal everything about your trades. Once you have enough data, let’s say hundreds or thousands of trades, a mix of paper trades and real trades, you will have your answer. If the number at the end is positive, you have a profitable trading system.
All that is left now is to execute it like a professional. And that is much easier said than done.
I’ve had a few good systems for a while now, but still struggle with my execution. I know they work, not work, they are a money-making machine in theory, but as soon as I enter the mix - the puny emotional, opinionated human, the whole system collapses. It’s not the system’s fault. It’s my inability to execute the system, that is the problem. I cannot help myself in wanting to save my losers, maximize my winner, overthink, and analyze every trade wanting to increase my odds.
The system only works if you execute it perfectly.
Mess with the system and you will get different results.
Personally, I can never outperform the most simple approach when testing my system, by overthinking and trying to beat its results. I come way short of just executing it without a thought in mind. As unintuitive, illogical, and simply wrong as this seems. It never fails to materialize.
If this is the case for you as well, you might want to focus more on a robotic style of trading. Set up a system with detailed rules and then just execute. Focus completely on the process and ignore the results. Only measuring your success after a longer period of time, after a large enough sample of trades. Any one particular trade doesn’t matter, it’s the whole sample that does. 100 or 1,000 trades for example.
The problem is that a robot (or a system) doesn’t care if it loses a few trades in a row, but you and I do. It also doesn’t get all cocky and overplay its hand.
This is an all too prevalent issue in systems that have a low win rate because you will be forced to take a lot of losers along the way. And there will be times when this will sap your motivation and plant seeds of doubt in your mind. This is the perfect time to open up old backtesting data, and trading journals and go do a few rounds of paper trading.
You need trust in your system and in your abilities to make it as a trader, or else you’ll collapse when met with adversity and it will come, as surely as the night descends on the planet.
Here’s another way to look at your trading expectancy, one I find a lot more useful. If we can stick to our system, even if we hit a rough patch, over 100 trades or so, we’re going to be just fine. Data proves this to us, even though emotions scream panic and fear.
The above examples illustrate that even with an appalling win rate, way below 50% (even 10% as seen above), a trader who manages to keep his losses contained, can still be OK. He or she will survive. R = risk unit, so if R = 1,000 USD, a trader is risking 1,000 USD on every trade. If he wins 3R, he makes 3,000 USD. Risk, not position size!
Notice one more thing in the above examples. There are no large losses allowed there! One large loss can completely wipe out your account and mess up the odds of your success.
The above examples illustrate that even if you have a godlike win rate, way above 50% or even 90%, and do not contain your losses to a minimum, you can take on serious damage. One mistake can completely annihilate your trading account!
Small, controlled losses are your friends,
while large, uncontrolled ones are your arch enemy!
Whenever I find myself doubting myself and my systems I go back to the data and reassure myself that even though I’ve hit a rough patch, I’m going to be just fine in the end. Carry on, as they say. My point is that you have to know your system and its characteristics and expected profitability in order to be able to keep on executing it when times get rough.
We all hit difficult periods in trading, it is inevitable.
The difference is in how you’ll handle them.
Will they lead to your financial ruin as you don’t have proper risk management in play?
Will they destroy your mentality and make you quit trading?
Or, will you be able to survive them financially and mentally, learning and growing, in order to thrive when the tides turn around for you?
Hope for the best, prepare for the worst, and keep on going. You can’t fail if you don’t quit or run out of money. Remember - win or lose, you’re making money (trading expectancy) on every trade if you are trading a system with an edge in the long run.
Disclaimer: Nothing here is financial advice, just a fellow trader meditating on his trading journey, sharing the lessons he learned, and debating some personal opinions that are only that opinions and nothing more.
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