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.
PROFIT EXPECTANCY EQUATION
AVERAGE PROFIT PER WINNER * PROBABILITY OF A WINNER
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|
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
(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.