Learn the Basics of Trading Expectancy

The idea of trading expectancy can be the difference between winning and profiting. Master trading expectancy and you don't even need to have more wins than losses to prosper. Let me explain. Despite the importance of risk management, I believe traders still under appreciate it. You see most people look at trading as a game of odds. You may be guilty of this too. True, it does contain odds, but odds alone do not tell the whole story.

When you look at trading systems, are you someone who only looks at the ratio of wins to losses? After all, it seems logical that a system that generates eight winning trades out of 10 is better than one that only has four out of 10... right? Not always.

Let's take Richard Dennis' Turtle trading system as an example. As I mentioned in chapter 4, this system won 40% of time and lost 60% - but it was still hugely successful. You see, it's not about how often you win, but also about how much you win. Winning and profiting are two completely different things.

Here's what I mean: If your system had an 80% chance of winning $100 and a 20% chance of losing $1,000, in the end you are bound to lose everything, despite the fact that you may experience many winning trades. Stringing together eight winning trades, valued at $100 each, followed by a couple of $1,000 losses will guarantee a trip to the poor house.

On the flip side, a couple of $1,000 wins is far better for your wallet than eight $100 losses, as demonstrated in the following scenario about system biases, commonly referred to as expectancy. Expectancy is just a fancy name for what I have just described.

Trade Expectancy is calculated as:

(% of wins x average win size) - (% of losses x average loss size)

So in our example we can see that:

(80% x $100) - (20% x $1000) or $80 - $200 = -$120

A trading system with these metrics has what is known as a negative expectancy. Compare that with our second example where the system has a positive expectancy and you could lose 80% of the time, yet still be profitable.

(20% x $1000) - (80% x $100) or $200 - $80 = +$120

Losing 80% of the time yet shows a profit of $120 per trade. Which situation would you rather find yourself in?

This is just one example, but learning to roll with the small losses as part of an overall strategy is something that would-be traders find difficult. And it's one reason why they are never truly successful. As mentioned previously, humans will instinctively take profits the moment they appear and ride losses until they are unbearable. Unfortunately, this is exactly what an 80:20 negative expectancy system looks like: taking lots of small wins, and losing all those profits - and more - to a few very large losses. Without clearly defined risk management rules you too will fall into this very large trap of trading.

And it's not only traders who apply these rules to their work - all the best professional poker players apply risk management rules to the way they play. I was once speaking to a player who told me that one of the risk management rules he applies is to never risk more than 2% of his entire gambling float in a single hand. In this way, he knows it is okay to lose a game here or there because it's only a small part of his overall purse. At the time I thought, 'Isn't that interesting? That's one of the rules I follow when trading'.

If you get your risk management rules set up right then your trading expectancy will guarantee returns over the long run.

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