Expectancy is an important concept in the world of trading, as it helps traders determine the potential profitability of a trading strategy over time.
By calculating expectancy, traders can assess the effectiveness of their strategies and make informed decisions on whether to continue or adjust their approach.
Let’s explore the concept of expectancy, its importance in trading, and how to calculate it.
What is Expectancy?
Expectancy, in the context of trading, is a statistical measure that estimates the average amount a trader can expect to win or lose per trade based on their historical performance.
It takes into account both the win rate (the percentage of trades that are winners) and the risk-reward ratio (the average gain of winning trades compared to the average loss of losing trades).
Why is Expectancy Important?
- Evaluating trading strategies: Expectancy helps traders evaluate the effectiveness of their trading strategies by quantifying their performance. A positive expectancy indicates that the strategy is profitable in the long run, while a negative expectancy suggests that the strategy will likely result in losses over time.
- Making informed decisions: By understanding the expectancy of their trading strategies, traders can make informed decisions on whether to continue using a particular approach, adjust it, or explore alternative strategies.
- Managing emotions: Expectancy can help traders manage their emotions by providing a statistical basis for their trading decisions. Knowing that a strategy has a positive expectancy can instill confidence in a trader, allowing them to trade more objectively and with less emotional interference.
- Risk management: Calculating expectancy can also aid in risk management, as it allows traders to set appropriate position sizes based on their trading performance and risk tolerance.
How to Calculate Expectancy
To calculate expectancy, you need to know the following:
- Win rate: The percentage of trades that are winners.
- Average win: The average gain of winning trades.
- Average loss: The average loss of losing trades.
Expectancy can be calculated using the following formula:
Expectancy = (Win rate x Average win) - ((1 - Win rate) x Average loss)
For example, let’s say a trader has a win rate of 60%, an average win of $100, and an average loss of $50.
Using the formula above, their expectancy would be:
Expectancy = (0.6 x $100) - ((1 - 0.6) x $50) Expectancy = $60 - $20 Expectancy = $40
This means that, on average, the trader can expect to make a profit of $40 per trade over time.
Why Positive Expectancy Matters
You might’ve heard two conflicting words of trading advice:
- “You can’t go broke taking profits!”
- “Cut your losses and let your winners run!”
So which is correct?
Taking quick profits can work….as long as losses are not big
Letting profits run can work…as long as the win rate is kept high.
It all boils down to having a positive expectancy!
How to Improve Your Expectancy
There are several ways traders can work on improving their expectancy:
- Enhancing the win rate: By refining their trading strategies and entry and exit criteria, traders can aim to increase their win rate, thus improving expectancy.
- Improving the risk-reward ratio: Traders can also focus on increasing the average gain of winning trades or minimizing the average loss of losing trades. This can be achieved through better risk management techniques, such as setting appropriate stop-loss and take-profit levels.
- Diversification: Diversifying trading strategies and instruments can help improve overall expectancy by spreading risk across various markets and reducing the impact of individual losing trades.