Trading Metrics
Expectancy
When it comes to trading, one of the most crucial metrics you need to understand is Expectancy. This metric is not just a number; it's a predictive tool that can significantly influence your trading decisions.
Expectancy helps you gauge the profitability of your trades by taking into account your past trading performance as well as the potential gains or losses of future trades.
What is Expectancy?
Expectancy is a calculation that helps you determine the expected profit or loss of a single trade after considering all your past trades and their outcomes.
In simpler terms, it tells you what you can "expect" to earn from a trade based on your trading history and the risk involved. If you're trading without understanding expectancy, you're essentially trading blindly, putting yourself at high risk of losing precious capital.
Components of Expectancy
To calculate Expectancy, you need to understand its components:
- Reward-to-Risk Ratio (RR): This ratio tells you how much money you can potentially earn for each dollar you risk on a trade.
- For example, if you're willing to risk $20 to potentially earn $40, your reward-to-risk ratio would be 40:20 or 2:1. In short, your RR is 2.
- Win Ratio: This is the percentage of trades you win. It's calculated by dividing the total number of winning trades by the total number of trades.
- For example, if you win 8 out of 20 trades, your win ratio would be 40%.
Profitability Across Various Win Ratios
A profitable system does not necessarily require a high Reward-to-Risk (RR) ratio and a high win rate.
To attain profitability, your breakeven win rate should be as follows:
Reward-to-risk | Breakeven Win Rate |
0.5 | 67% |
1 | 50% |
2 | ⅓ or ~33% |
3 | 25% |
5 | 17% |
10 | 9% |
For instance, if you consistently risk $1 to potentially earn $2 (equating to an RR of 2), your breakeven win rate would be 33%. At breakeven, your expectancy will be 0.
Calculating Expectancy
Expectancy can be calculated in both percentage and dollar terms using the Reward-to-Risk Ratio (RR) and Win Ratio. This approach allows traders to measure profitability clearly and concisely.
1. Expectancy in Percentage Terms
To calculate expectancy as a percentage, use the following formula:
Expectancy (%) = (Win Ratio * RR) - (1 - Win Ratio)Example Calculation:
- Reward-to-Risk Ratio (RR): 2
- Win Ratio: 40%
Expectancy (%) = (0.4 * 2) - (1 - 0.4)
= 0.8 - 0.6
= 0.2 or 20%Meaning: On average, you can expect to gain 20% of your risk amount per trade, indicating a likely profitable strategy.
2. Expectancy in Dollar Terms
To calculate expectancy in monetary terms, use the same formula but multiply the result by the average amount risked per trade:
Expectancy ($) = [(Win Ratio * RR) - (1 - Win Ratio)] * Average Loss $Example Calculation:
- Reward-to-Risk Ratio (RR): 2
- Win Ratio: 40%
- Average Loss: $100
Expectancy ($) = [(0.4 * 2) - (1 - 0.4)] * 100
= [0.8 - 0.6] * 100
= 0.2 * 100
= $20Meaning: On average, you can expect to earn $20 per trade, indicating a profitable strategy based on your risk level.
Interpreting Expectancy
- A positive expectancy in percentage or dollar terms indicates a strategy that is likely to generate profits over time.
- A negative expectancy suggests a need to re-evaluate the strategy to avoid sustained losses.
By combining expectancy in both percentage and dollar terms, traders can better understand the impact of their strategy on their portfolio and make more informed decisions.
Limitations and Considerations
Past Data Trading expectancy relies on historical data, which may not accurately reflect future market conditions. Positive expectancy doesn't guarantee future profits.
Sufficient Data Accurate expectancy calculations require a substantial amount of historical data. Inadequate data can lead to unreliable results. Using data for the past week or the last 10 trades is likely not representative of your strategy’s performance.
Manual Overriding
Changing SL, TP or risk when running trades → recommended to run automatically to avoid psychological pitfalls
Conclusion
Understanding Expectancy is vital for any retail trader. It not only helps you evaluate the profitability of your trades but also serves as a tool for comparing different trading strategies.
A positive Expectancy is a good sign, but always consider other variables to make the most informed trading decisions.