PROFIT EXPECTANCY

If you read any basic book on trading you will have it ingrained in your head that one must only take a trade if the profit is greater than the risk taken. In reality, I know many successful traders who regularly risk more than they make on any given trade but what these traders do understand is the profit expectancy of their system/strategy. Most retail investors only focus on entry and exit and standard risk/reward for their trades and a true understanding of the expectancy of a strategy often goes awash.

Profit expectancy refers to how much you can make vs each pound (GBP) risked on a trade. (Tweet this)

PROFIT EXPECTANCY EQUATION

AVERAGE PROFIT PER WINNER * PROBABILITY OF A WINNER

MINUS (-)

AVERAGE LOSS PER LOSING TRADE * PROBABILITY OF LOSING

= HOW MUCH PROFIT PER TRADE YOU WOULD EXPECT TO AVERAGE OVERTIME

We can use a previous example of my lifestyle trades as a case example. This is one of my systems where I regularly risk more than I gain on any one trade. On face value, this would get scrutinised by a retail investor but by applying the above formula one can see that the overall strategy is very profitable.

BUY OR SELL STOP TARGET WIN/LOSS PROFIT/LOSS
SELL at 5679 22 5650 WIN 29
SELL at 5723 22 5694 WIN 29
SELL at 5767 19 5753 WIN 14
SELL at 5808 23 5791 WIN 17
SELL at 5890 18 5870 LOSS (-) 18
SELL at 5920 17 5890 WIN 17
SELL at 5935 15 5917 WIN 18
SELL at 5927 15 5921 WIN 6
SELL at 5814 18 5793 LOSS (-) 18
SELL at 5922 17 5914 WIN 8
BUY at 5852 19 5868 WIN 16
BUY at 5794 19 5806 WIN 12
SELL at 5884 22 5876 WIN 8
BUY at 5823 21 5836 LOSS (-) 21
SELL at 5716 22 5705 WIN 11
BUY at 5578 27 5593 WIN 15
BUY at 5665 25 5674 WIN 9
SELL at 5747 23 5733 WIN 14
SELL at 5725 24 5702 WIN 23
SELL at 5737 22 5718 LOSS (-) 22
SELL at 5789 21 5777 WIN 12
BUY at 5556 27 5580 LOSS (-) 27

EXAMPLE

For the above data we will see there are 22 overall trades of which 17 are winners and 5 are loses. This provides a win rate of 77% and a loss rate of 23%

The average loss is 21 points and the average win is 15 points

If we assume we are trading 10 pounds a point for each trade.

If we apply this data into the above formula we get:

(150*0.77) = 115

minus

(210*0.23) = 48

115 – 48 = 67

Any system with a profit expectancy over zero makes money over time

So even though we are risking more on this system we have a profit expectancy of 67 pounds for each trade over time.

I prefer adopting a strategy which has a high win rate to keep my confidence high however you could have a strategy with a 23% win rate and still be profitable but what is vital is you understand the profit expectancy of your system/strategy rather than just focusing on risk/reward. Remember trading is a business and without working out expectancy in your strategy, you do not have a complete business plan.

Happy Trading!

Mark

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