Trading system expectancy formula

Trading system expectancy formula

Posted: Romeo! Date: 23.05.2017

When you first started to trade, how did you judge your results? If you're like most novice traders you likely had little understanding of the concept of trading expectancy, so you focused almost entirely on your win rate in the early days. You were probably trying to win 80 or even 90 percent of the time and it was a constant struggle.

You may have been able to achieve it for a short period of time, but your small wins just couldn't cover the big losses and once you hit an "unlucky" string of losing trades you just couldn't recover. While very high win rates can be achieved by experienced traders or those with a system that allows huge draw-down, it's extremely difficult for most new traders to sustain these percentages as their various trading errors and impatience get the best of them.

From there you might have shifted your focus to your ratio of reward to risk. As long as you could win more on average than you lost, you could make trading work and be profitable.

You might have been looking for 3 or even 4 times as much profit on a winner compared to a regular loss, but still the struggles continued.

Your win rate dropped dramatically, and even the odd big win wasn't enough to pay for the strings of losses. Here's the thing that you don't often hear on the trading forums - your win rate alone isn't that important and neither is your reward to risk ratio.

What really matters is what happens when you combine the two to determine your trading expectancy. Simply put, your trading expectancy is the average amount you can expect to win or lose per trade with your system, when a large number of trades are taken at least thirty to be statistically significant. To calculate your trading expectancy, you need to know three things - your win percentage, your average win, and your average loss.

The calculation is as follows:.

The impact this knowledge can have on a trader's confidence, patience, and discipline shouldn't be understated. It's easy to understand the power of expectancy by thinking of a casino. The casino has many games which have a small positive expectancy in their favour. The edge for the casino is small enough that the players can go on long winning streaks and make good profits in the short term thus inspiring false confidence , but if they continue to play over the long term the numbers will be in the casino's favour as, on average, they will make a few pennies for each dollar the player risks.

The casino always beats the masses in the long run. As traders, we can effectively be the casino while sustaining a much larger positive expectancy at the same time. Profitable trading systems can come in many permutations, so we will look at cases with different win rates, average wins, and average losses.

We will also consider a system which has an extremely high win rate, but still fails to be profitable over the long term due to a negative expectancy. In this example, we see the kind of trading system results that many novice traders aim for but struggle to achieve.

This leads to a strong positive expectancy as we can see. The downside of this scenario is that it's often extremely difficult to replicate. Even armed with a system that should win a high percentage of trades if properly followed, a novice trader will have trouble achieving such a high win rate.

Impatience, emotional fear, and a host of other issues are likely to interfere with a new trader following their trading plan, and even slight deviations from the high win rate can cause the positive expectancy of a system to disappear.

In this example we have a trader with a very healthy reward to risk ratio where the average win is just over twice as large as the average loss. Unlike the previous example, a trading system such as this one is much easier for the novice trader to find consistency with.

The pressure of maintaining a high win rate is reduced, a few rookie mistakes won't kill the trading edge, and the excellent reward to risk will quickly cover a small string of losing trades.

These numbers in this example are close to what we strive for with novice students in the STA Training Program , though veteran traders often see a better win percentage when using our day trading system due to their additional experience. In this example we look at a trader who focuses on keeping their average wins as large as possible compared to their average loss.

Although the system wins less than 1 out of 3 trades, the impact of an excellent reward to risk ratio allows for a substantial positive expectancy on their trades.

These lower win rate systems can be extremely powerful with a large positive trading expectancy, but they can also suffer from long periods of drawdown with strings of losses. Again, this is a difficult scenario for a new trader, as they will often find themselves changing their approach rather than giving the system time and allowing the trading edge to come through over a larger number of trades.

Many professional traders have built their careers off systems with a low win percentage, but with wins that are many times larger than their average loss.

Most trend followers would be in this group. They may take a lot of losses when the market moves sideways, but once they hit a trend they take large profits that cover the losses and then some. As legendary trend following trader Ed Seykota says, "one good trend pays for them all". Even when systems like this have a small positive expectancy, they can still run into major problems. This kind of massive draw-down means a huge dent in your equity which is extremely difficult to pull yourself out of, especially if adjusting position sizing to a lower amount to compensate for the loss.

In a future article we'll explore draw-down and position sizing further to show this effect clearly.

The natural bias that most people have is to go for high probability systems with high reliability. We all are given this bias that you need to be right. Nothing below 70 is acceptable. Everyone is looking for high reliability entry systems, but it's expectancy that is the key. And the real key to expectancy is how you get out of the markets not how you get in. How you take profits and how you get out of a bad position to protect your assets.

How To Calculate Expectancy of Your Forex Trading System | Forex Social Traders

While knowing our trading expectancy is important, there are other factors that come into play which can complicate things a bit. Here's a few things you should consider when evaluating the strength of your system and overall trading plan:.

If you have a large positive trading expectancy there's no doubt you've got a powerful trading approach, but you also need to consider how often trades will become available.

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Your system may have a great positive expectancy, but if it only finds a valid trade once or twice a month it may be inferior in terms of returns compared to a system that has a much lower per trade expectancy but trades 5 or 6 times per day.

When position sizing and the possibilities of compounding are considered as well, the frequency of trading opportunities can have a huge impact on returns. Something a lot of new traders ignore to their peril is the impact of trading costs on their results.

While the round-trip costs in terms of commissions and exchange fees may seem small on a single trade, when you trade often with a system with a small positive expectancy, it can quickly eat away your profits or even turn your expectancy negative. Your approach needs to have a large enough positive trading expectancy to handle your costs with plenty of room to spare. Expectancy and position sizing go hand-in-hand. Even with a large positive expectancy, erratic position sizing can quickly shift your results into dangerous territory.

Keep your position sizing within tolerable levels and consistent and you will give your trading edge the time and quantity of trades it needs to properly play out. It's important to keep in mind that if you are testing your expectancy using historical data such as the Market Replay function in NinjaTrader , there's no guarantee that you will have a similar edge in the future.

It's still vital to do this testing in order to build confidence in your methodology, but be wary of "curve-fitting" your approach to the historical data as things are unlikely to play out the exact same way for future trades.

One of the biggest mistakes that all traders make is that they enter the competitive battlefield that is the markets without knowing their trading edge. Just as it would be foolish for the samurai warrior to enter a battle without knowing the quality and condition of his chosen weapon and armour, a trader must know the quality of his or her trading edge. Without this knowledge, how can one be confident in the face of adversity? Only through research, testing, and focused practice sessions can a trader be fully confident of their edge and overall trading expectancy.

You need to have an intimate knowledge of your trading plan and confidence in your ability to execute it with precision if you want to succeed on the battlefield. Many would-be traders have fallen due to a lack of preparation. Don't be one of them. Know your trading expectancy, embrace your edge, keep your discipline, and carve out your piece of the market with confidence. The Path to Becoming a Full Time Trader Building and Refining Your Trading Edge 4 Keys to Breaking Your Trading Plateau Strike While The Iron is Hot The 7 Best Price Action Patterns Trading Expectancy: The Power of an Edge Why You Don't Want to Be a Pattern Day Trader.

Futures trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing ones financial security or life style. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results. Facebook Youtube Rss Gplus Linkedin Twitter.

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