Expectancy

Expectancy is a crucial concept in trading, as it enables traders to evaluate the potential profitability of their trading strategies over time. By calculating expectancy, traders can gauge the effectiveness of their strategies and make informed choices about whether to maintain or modify their approach. Let’s delve into the concept of expectancy, its significance in trading, and the method for calculating it.

What is Expectancy?

In trading, expectancy is a statistical measure that predicts the average amount a trader can expect to win or lose per trade based on their past performance. It considers both the win rate (the percentage of successful trades) and the risk-reward ratio (the average profit from winning trades compared to the average loss from losing trades).

Why is Expectancy Important?

Evaluating trading strategies: Expectancy assists traders in assessing the effectiveness of their trading strategies by quantifying their performance. A positive expectancy indicates that the strategy is likely to be profitable in the long run, while a negative expectancy suggests potential losses over time.

Making informed decisions: Understanding the expectancy of their trading strategies allows traders to make informed decisions about whether to persist with a specific approach, modify it, or consider alternative strategies.

Managing emotions: Expectancy can help traders regulate their emotions by providing a statistical foundation for their trading decisions. Knowing that a strategy has a positive expectancy can boost a trader's confidence, enabling them to trade more rationally and with reduced emotional influence.

Risk management: Calculating expectancy also supports risk management, as it helps traders determine suitable 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 instance, if a trader has a win rate of 60%, an average win of $100, and an average loss of $50, their expectancy would be:

Expectancy = (0.6 x $100) - ((1 - 0.6) x $50)
Expectancy = $60 - $20
Expectancy = $40

This indicates that, on average, the trader can expect to earn a profit of $40 per trade over time.

Why Positive Expectancy Matters

You may have encountered two seemingly contradictory pieces of trading advice:

• “You can’t go broke taking profits!”
• “Cut your losses and let your winners run!”

So, which one is correct?

Taking quick profits can be effective, provided that losses are kept small. Letting profits run can also be successful, as long as the win rate remains high. Ultimately, it all comes down to maintaining a positive expectancy!

How to Improve Your Expectancy

There are several strategies traders can employ to enhance their expectancy:

• Enhancing the win rate: By refining their trading strategies and entry and exit criteria, traders can strive to increase their win rate, thereby improving expectancy.
• Improving the risk-reward ratio: Traders can focus on boosting 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 enhance overall expectancy by spreading risk across various markets and mitigating the impact of individual losing trades.