Many traders wonder how to measure the effectiveness and reliability of their strategy. They want to know how much they can expect to earn or lose per trade with their current trading system. This is where trading expectancy comes in handy. Trading expectancy is a term that describes the average outcome of a trade based on the historical performance of a trader. It can help traders improve their trading results by showing them how to optimize their strategy. Or, if you are looking at two different trading systems, how do you know which one is better? There are different criteria for “better”, naturally; but which system is more reliable, consistent, or which generates the most profit. Another thing you might be looking at is which times of day are the most effective for trading.
Well, there is a method to calculate that: Expectancy.
Expectancy is a mathematical formula (or algorithm) that you can use to determine how reliable your system is at generating profits (or losses). It can also help identify if your trading is off for factors outside your plan, which is useful to head off problems that might not be as evident in a fast-paced environment of trading.
How it works is going over your recent trades (or trades for a specific time you want to analyze) and then comparing profitable trades to losing trades. Add a little math, and it will show how much you should make on average for trading using that system. You can do it with as few as a dozen trades; but the more trading history you input, the more consistent the result will likely be. Also, to expand the number of trades you are putting into the calculation, you can add back testing as well. Or compare back testing over a period to your real-world trading.
How does it work?
To calculate expectancy, you multiply the percentage of trades you won times the average amount of profit and then subtract the percentage of loss times the average loss.
Expectancy = (win rate * average win) – (loss rate * average loss)
Obviously, it won’t predict how much you will make in the future, since trading conditions change. And it won’t necessarily be the same every day for the same reason. But it can give you some guidance and provide an outline for further investigation.
Applying it to your trading
For example, if you did 10 trades, and 6 of them were winners, you have a 60%-win rate. Which is about average for most traders. If you add up all your wins and they come out to, say $1,200, then you divide by the number of winning trades, and your average win is $200. Since six of the ten trades were winners, then the four remaining were losers. Let’s say you lose the same amount per trade as you win:
Expectancy = (60% * $200) – (40% * $200) = $40.
In other words, on average, you could expect to make around $40 per trade in that system.
This might come in handy if you must compare two trading systems/strategies. One might give more signals but have a lower win ratio. Which one will likely generate the most profit over time? Expectancy might give you the answer.
