What Are You Expecting from Your Trading?

10/22/2010 12:01 am EST

Focus: STRATEGIES

Several weeks ago, my trading partner Scott Andrews had the great privilege of enjoying lunch with Dr. Van Tharp. Dr. Tharp is a world-renowned author of some of my favorite trading books, including Trade Your Way to Financial Freedom and Super Trader. Over the years, Dr. Tharp has espoused many pearls of trading wisdom.

One of my favorites is his assertion that the entry technique may be the least important of the ten or so different elements of a trading system or methodology. I could not agree more. For years, I have traded the opening gap by simply entering at the open of the equity and futures markets in New York and Chicago (9:30 am ET). It is simple, easily repeatable, and requires zero skill. Despite my success, I used to be embarrassed by my lack of sophistication when entering gap trades. Now I realize that it may be one of the greatest strengths of my strategy.

However, many traders obsess over studying price charts. They believe that the key to success is anticipating the market’s next directional move. How many times have you waited patiently for that perfect set-up and then been stopped out immediately before prices turned and hit your target? Or worse, had it trade to within pennies of your target, then reverse and stop you out? Being right directionally and entering at the right time is simply not enough. You must also determine the optimal exit for both your profit target and your stop.

But how? Many traders tinker with their target and exit strategies until they finally achieve a set of parameters that generates a psychologically acceptable win percentage. Unfortunately, this acceptable win rate rarely generates much, if any, profits, over time. Why? Because the markets are exceedingly efficient over the long term and the profit expectancy for most set-ups is near zero.

Profit Expectancy (PE) = (probability of winning trade * average size of winner) – (probability of losing trade * average size of loss)

I know formulas are more effective than an Ambien sleeping aid for many, but seriously, if you do not know the PE (expectancy) of your trading strategy or technique, stop trading. 

To consistently extract profits from the markets, you must be able to determine the optimal stop and target placement for each trade (something I find to be very difficult due to the subjective discretion required). Or, you must be able to identify positive profit-expectancy set-ups from negative profit-expectancy setups. If not, then it is just a matter of time before your account starts impersonating The Titanic.

For every dollar made in the markets, there is a dollar lost. It is a brutal zero-sum game. If you are struggling, then maybe it’s time to focus on high-expectancy trades and let history be your guide. 

By Tim Mock of MasterTheGap.com

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