Do You “Expect” to Trade Well?

06/20/2011 11:15 am EST

Focus: STRATEGIES

The concept of “expectancy”—how often a trader wins and loses—and more importantly, how they limit their losses, is an essential measure that separates beginners from successful, seasoned veterans.

Math plays a big part in a trader's life, but not in the way you might think. People who attend business school are first taught to read a company's balance sheet—the fundamentals, as they are called on Wall Street. Under this evaluation method, the overall financial health of a company is determined by perusing its books (assuming what's in the books is legitimate) and an assessment is made as to the worthiness of ownership of its shares.

What's the cash flow? How much debt is on books? What is the burn rate? These are just a few of the questions that are important to those who spend their time analyzing companies. In the end, all this is of little consequence in the short term, as the movement of the major market indices has a much greater influence on the price of the security than any of the underlying fundamentals.

One of the traps investors fall into is the misguided perception that if they do their math, and buy so-called "good companies" during the downturns, they will somehow be spared of any losses. The reality is that bear markets take the majority of stocks down.

In that respect, there is an upside value created during downturns. In other words, those "good companies" get marked down to wholesale levels, thus becoming great buys. Unfortunately, most investors buy these stocks when the good fundamentals are fully reflected in the price, or even worse, when they are overpriced.

I'm not suggesting that the fundamentals in the market be entirely dismissed. All I'm saying is that price is far more important, and to be precise, real buying and selling, as indentified by supply and demand levels, will be more productive in the pursuit of profits than any other matrix of valuation.

Now, to the math that really matters: One aspect of trading that is not talked about often, and is, in my opinion, one of the most important aspects, is something called “expectancy.” This is simply having an idea of how often, in percentage terms, you are profitable, and gauging how much is lost and gained.

NEXT: The Most Important Win/Loss Factors to Measure

|pagebreak|

Let's go through various examples to show how important this is. We'll start by looking at how often we lose or win. We'll say that of 30 trades, we made money on half of them, leaving us with a 50% win rate.

Now, here are the most important questions for a trader: How much, on average, was lost when stopped out, and what were the profits on the winning trades?

A positive expectancy would look like this: Average loss of $100 versus an average profit of $500 being right 50% of the time. In this example, using 30 trades as a basis, the trader would have a gross profit (excluding commissions) of $6000 ($7500-$1500) even though he was stopped out half the time.

Let's increase the win/loss ratio to 70% and say that the average loser was about $150 and the winners were running at about $100 a pop. Here, the trader ends up with a paltry $750 profit, not including commissions, even though he is "right" 20% more often than the first trader.

In addition, one bad trade by this trader can throw the bottom line into the red very easily. So you see, it's not just about being right often, but how much is lost or gained on every trade.

To their credit, there are a handful of scalpers who trade with a risk/reward of one-to-one and have a very high win rate. This is a very elite group and very hard to achieve for the majority. If this is a style of trading that suits your personality, you will definitely need some mentoring and lots of hard work.

Understanding statistics, both in expectancy and in backtesting a strategy is where we differentiate the mind of a professional trader from that of a novice. The novice is focused on finding the “Holy Grail,” always wanting to win and looking to be right with no regard to expectancy.

Video: There’s No “Holy Grail” Indicator

On the other hand, a pro is paying close attention to keeping winners at a good margin versus losers, and understanding probabilities. This then turns trading into a statistical endeavor, rather than one based on emotions. Incidentally, some of the most profitable systems have a win/loss ratio of about 30%, but as you might imagine, they have a very high expectancy rate.

See related: Why P&L Doesn’t Determine Success

For novice traders, it is very tough to stomach even a 50% loss rate, let alone 70%, and that's why it's important to understand this concept of losing small and winning bigger. This is why our mantra at Online Trading Academy is "Low risk, high reward, high-probability trading," because this and good execution is the only way to consistent profitability.

By Gabe Velazquez of Online Trading Academy

Related Articles on STRATEGIES