Calculating Trading Expectancy
Do you enter trades with all guns blazing or do you meander just on the outside, calculate your trading expectancy and enter only when the odds are in your favor? Most traders don’t but there are so many reasons why you should calculate trading expectancy!
Trading Expectancy – What Is It?
In simple words, the average amount traders can expect to win or lose per trade (with their system) is known as trading expectancy. In this case, at least 30 or similarly large number of trades are statistically the same. How can you calculate trading expectancy? You will have to find out:
o Win percentage
o Average loss
o Average win
As explained above, trading expectancy is that amount which traders can expect to win or lose in every trade. This should make the trading expectancy calculation formula as:
Trading Expectancy Formula
Expectancy = (Win Probability + Average Win) – (Loss Probability + Average Loss)
While it’s a fairly simple equation to understand and apply, knowledge gained from calculating trading expectancy can severely test any level trader’s confidence, patience and discipline.
How-to Calculate Trading Expectancy
There are basically two types or categories of trading systems; Trend Following and Countertrend trading systems. Some traders are of the mindset that there isn’t any such thing as a profitable trading system, as it solely depends on the trader how each trade is conducted. In actuality, (profitable) trading systems feature high number of variations i.e. trades can be arranged to show different win rates, average wins, and even average losses. There are also some trading systems that feature an extremely high win rate but fail to perform profitably due to negative expectancy.
Imagined Case Study For The Sake Of Explaining Trading Expectancy and How-to Calculate
Since simple examples always help understand something far better than complex ones, assume you are taking $100,000 positions and risking $1,000 (or 1%) position on each trade. As mentioned above, trading systems feature many permutations or variances, which are:
1. High Win Rate plus Moderate Reward to Risk Trading System
This is a result that many novice traders aim to achieve but fail. A high win rate plus moderate reward to risk trading system offers 80% of wins in 100 positions. Average reward or profit won is slightly less than average risk or loss experienced. This automatically leads to a strong positive expectancy. How? Expected win on an average profit of $360 for each trade with $1,000 risk that is made.
Calculating Trading Expectancy: (0.80 * $700) – (0.20 * $1,000) = $360
2. Moderate Win Rate plus High Reward to Risk Trading System
Assume you have a very healthy reward to risk ratio in this example, where average win is almost twice as large as average loss. In fact, average loss has reduced to significantly less because overall risk and stop levels are being managed actively. This means most losses incurred are considerably low and reduce overall average (of loss) even if hitting $1,000 which is the maximum initial stop. Moreover, overall trading expectancy improves significantly although win rate is reduced to 55%.
Calculating Trading Expectancy: (0.55 * $1,600) – (0.45 * $700) = $565
3. Low Win Rate plus Very High Reward to Risk Trading System
This example shows a trader focusing on keeping their average wins as high as possible. An excellent reward to risk ratio allows a substantial positive expectancy on conducted trades even though trading system wins less than 1 out of 3 trades! As such, this lower win rate system can prove to be incredibly powerful (having a large positive trading expectancy) however traders often change their approach mid-trade due to lack of discipline, patience and foresight. Legendary trend following trader Ed Seykota says, “One good trend sometimes pays for all the bad ones”. This is especially true for this trading system.
Calculating Trading Expectancy: (0.3 * $1,800) – (0.7 * $400) = $260
4. Very High Win Rate plus Very Low Reward to Risk Trading System
Even in the case of 95% win rate, success is sometimes not guaranteed as explained in the first example. It may seem crazy to take on wins that are only $40 (average) with $1,000 average loss however traders actually implement similar strategies quite frequently! Traders can still experience major issues even when there is a small positive expectancy rate on such trading systems. Look at the example of calculated trading expectancy below. Even with loss probability of only 5% trades, multiple losses are expected to be incurred over a brief period.
Calculating Trading Expectancy: (0.95 * $40) – (0.05 * $1,000) = -$12
It’s about time that emphasis and importance on only the trader shifted to include the trading system chosen. There are many options available in the market, i.e. different types of trading systems with different expectancy, winning rates and trading rules. Already have a trading system? If it’s a good one, your trading system (regardless of type) should be:
o Able to limit risks
o Able to make money
o Stable to use and feasible
Some other considerations to keep in mind when selecting a trading system are:
o Should be based on sound trading strategy
o Offer positive expectancy
o Ability to trade with available amount of risk capital
o Provides the right number of trades to promote prioritization
o Is consistently profitable overtime and offers robust qualities
o Can fit into your daily routine and is in accordance with your personality
o Doesn’t require traders to monitor markets all day
o Allows traders to copy trades and strategies in their forex trading journal or plan
o Generates most profit after all above markers are satisfied
Above mentioned considerations can help traders find the best trading system for them however even the best doesn’t hold a candle to AlpsSocial. Why? Find out by signing up today!