In my last post, I mentioned that if you control your downside, your upside will take care if itself. Some of you will be wondering how could that be! Then I believe it's time to explain trade expectancy. This is a concept most commonly used by the casinos, high frequency traders and forex traders.
Before we go on, (for those who have not yet read my previous post) , A Thing Called Risk is the first part of achieving profits with 50% win rate. If you do not understand or have not made it into a habit to set your maximum risk per trade, it is best to go to the link to read and re-read until it is second nature before continuing.
Let's play a game of coin flipping. If you win, I will pay you $1. If you lose, you will pay me $2, After >100 rounds, I would always be profitable. Why? Because the expectancy ratio is better for me. A coin has a near 50-50% chance of being either heads or tails given enough flips. If you try it only for 10 rounds, you may get 7-3 or 8-2. But try it for 100 rounds or even 1000 rounds and you may get around 50% (may not be exactly 50%).
Apply this game to your trades. Let's say you have a $100 account and by limiting the risk per trade mentioned in the link above, you set the maximum risk as $1. But your only enter trades which you have a possible reward of > $2. This is what we call a Risk-Reward Ratio of 1:2 where you risk $1 for a reward of $2.
Steps for developing expectancy
1. Calculate % of Winning trades and Losing trades
2. Calculate Average Win and Average Loss
3. Obtain Trade Expectancy = (% Win x Average Win) - (% Loss x Average Loss)
Lets determine a 50% win rate (either you decide by flipping a coin or base it on you gut feeling)
1. % Win : % Loss Ratio = 50% : 50%
2. Average Win : Average Loss Ratio = 2 : 1
3. Trade Expectancy = (50% x $2) - (50% x $1) = $0.5 per trade (0.5% of a $100 account )
Trade Expectancy Ratio means that you are expected to win $0.5/trade in the long run. Everything is just a numbers game in the world of trading. If you got a negative number, you need to review your numbers (Win : Loss %, Average Win or Average Loss) and concentrate on making your numbers better by limiting your losses while letting your profits run.
In fact, with a winning ratio of 34%, you can also be profitable. Because the Trade Expectancy = (34% x $2) - (66% x $1) = $0.02 per trade.
Although this has very little to do with investing and is more relevant to traders, it is important to limit your losses before your blow up your account.
Below is a chart to illustrate the effects of drawdowns on the account. As you will see, the more you lose, the more difficult it becomes to regain your original capital. So the important lesson is to Limit Losses before they take you out of the game.
Disclaimer: This is not a recommendation to buy or sell any mentioned stocks or securities in this blog.