Two areas of trading that are often much overlooked by both beginners and quite experienced traders are money management and position sizing. Both of these important areas are covered in detail during the beginners course 1-2-1.
However In this short article I wanted to quickly cover one aspect of money management which is trade expectancy.
Novice traders are especially keen to find out what the win loss ratio is of any system. They tend to assume that a system with a 90% winning ratio is superior to a system with say a 60% winning ratio. Certainly the former system will be more psychologically easy to trade but may still not yield any profit.
The correct way of looking at this aspect of performance is expectancy.
Expectancy is essentially the percentage winners times what you win on each trade less the percentage losers times what you lose on each trade.
So a simple example would be a system with 80% winners when each winner averages $10 and each loser averages $6.
The expectancy of the system is therefore (80% * $10) –(20% * $6) = $8-$1.20 = $6.80
So what we are saying is on average every trade you place whether it is a winner or a loser will make you $6.80 profit.
Remember in trading we are only interested in probabilities not in specific individual outcomes. So in the long run it doesn’t matter whether your next individual trade is a winner or loser. What does matter is that after 100 or 1000 trades you are in profit.
We can check our arithmetic by assuming we have placed 10 trades eight of which would win us $10 and two of which would lose us $6. So over those 10 trades we would win $80 and lose $12 making a net profit of $68. Which when divided by the number of trades gives us the average trade profit of $6.80.
Ii is therefore easy to see the fallacy of simply asking what the percentage winners are. For instance you could have a system that wins 90% of the time and loses 10% of the time but still has a negative expectancy. Also the reverse could also apply.
Often in those $99 ads on the Internet you will see claims such as 80% winners or even 90% winners. This is almost always a warning sign because the seller realises, that in isolation , this quoted percentage is almost meaningless.
It is a bit like saying petrol is a bargain because it only costs $10…… And never completing the sentence to say how much petrol you get for $10. I could be $10 for a gallon or $10 for a thimble full. To say a system has 90% winners is an almost equally meaningless statement.
Whilst lack of understanding of expectancy is the main reason for people obsessing about percentage winners it is also, to some extent, psychologically hard wired into us. The natural bias for people is to go for systems with high winning percentages. Certainly they are psychologically easier to trade and give us regular rewards and psychological reinforcement that what we are doing is “correct” and “right” . Most of us have a psychological need to be right and just hate being wrong so high probability systems play up to this.
The problem is in trading it can be exactly the wrong thing to do. You will often find that good trading systems do not have stunningly high win loss ratios but still produce high positive expectancy. This is the case for very good reasons that are covered elsewhere.
So forget obsessing about win loss ratios and instead obsessive about expectancy. Understand that the vendor that just quotes the win loss ratio is playing to people’s misunderstandings and is therefore unlikely to be a particularly honest chap.