Trading Expectancy and How it Works
Trading expectancy is a calculation that shows what the typical profit is for each trade placed. If it’s negative, the strategy is a loser. If it’s positive, the strategy is a winner. The calculation combines how many trades are typically won with the average loss on losers and the average gain on winners.
While knowing the expectancy of a strategy is important, expectancy also highlights that there isn’t just one way to make a profit. A trader can lose almost all their trades, but if their wins are much bigger than their losses they can still make a good income. On the flip side, there may be a trader that wins almost all the time, but because their losses are so much bigger than their gains they end losing money overall.
Trading Expectancy is About Odds and the Size of Wins and Losses
Many new traders only think about trading in terms of winning. They don’t like losing and so they are always trying to (or hoping to) win 8, 9 or 10 trades out of every 10 they take. While winning 8 or 9 trades out of 10 may be possible, it doesn’t mean that trader will be successful over time. There is nothing wrong with winning! Many traders do very well by winning 7 or 8 trades out of 10. The point is, odds alone don’t tell the whole story.
How many trades we win or lose isn’t the only thing to consider. Also consider the size of those wins and losses. By combining these factors we see that it is possible to have successful traders with high rates and low win rates.
Calculating Trade Expectancy
Here’s how to calculate trade expectancy, then we’ll look at some scenarios.
(Win % x Average Win Size) – (Loss % x Average Loss Size)
Input the percentages as a decimal. For example, 80% is 0.8.
Consider Richard Dennis and the Turtles. Their system often won less than 30% of time, some of the Turtles even won less than 15% of the time, but the strategy still made them money. That’s because their wins were so much bigger than their losers. There is a big difference between winning and profiting.
Let’s assume someone using a similar strategy only wins 20% of the time, but they make $1000 when they win and they lose $100 when they lose.
(0.2 x $1000) – (0.8 x $100) = $200 – $80 = $120
The number is positive, which shows the strategy has a positive expectancy. It is making money. But what does the $120 mean? The expectancy is the average return for each trade, including wins and losses. This trader is expected to win 2 out of 10 trades, resulting in $2000 in gains. They are also expected to lose 8 trades out of 10, resulting in losses of $800. Subtracting the $800 dollars in losses from the $2000 gained, the trader is left with a gain of $1200 over 10 trades. How much did they make on average per trade? $1200 divided by 10 is $120. Therefore, trading expectancy is what we expect to make on each trade, based on our win rate and average gains and losses.
A classic trader mistake is to take small profits hoping to win all the time, but then letting the losing trades get out of hand. Consider a trader who wins 70% of the time, making $150 on average when they win but losing $400 on losing trades.
(0.7 x $150) – (0.3 x $400) = $105 – $120 = -$15
For every trade this trader places they can expect, on average, that $15 will drain from their account. Over 10 trades they can expect to lose $150. With a negative expectancy, the more trades taken the more money that is lost. This trader may win often, but they aren’t profitable.
How can this trader become more profitable? Probably the easiest fix is to try to reduce the size of the losses, potentially with a stop loss order. If this trader can reduce losses to say $200, they will be profitable, even though the wins are only $150. This is because this trader is winning more than they are losing.
(0.7 x $150) – (0.3 x $200) = $105 – $60= $45
By reducing the size of losses, this trader can now expect to make $45, on average, every time they make a trade.
The trader could also refine their method so they are making more on winning trades. This could also swing the strategy into profitable territory. Since the win rate is already quite high at 70%, it will be hard to improve on that. Therefore, effort is best spent on reducing the size of losses or increasing the size of winners.
If your win rate is below 50%, your wins must be larger than your losses in order to produce an overall profit. The lower the win rate, the larger those wins need to be relative to the losses.
If your win rate is above 50%, your wins can be bigger or smaller than your losses. Bigger wins than losses is ideal. The higher the win rate, the larger the losses can be relative to the win size.
In all cases, risk must be controlled. Ideally, keep risk to less than 2% of trading capital.
Trade Expectancy Over Time
Trade expectancy only really matters over many trades. While 10 trades were used in the examples above to keep it simple, 10 trades means nothing. It is a statistical blip. To get a reasonably trade expectancy, look at results over 50 trades, or preferably 100 or more. Over that many trades we start to get a truer sense of how a strategy performs.
Over time, things change. Market conditions change and we change. That means that our trade expectancy may change over time. That is okay. Changes in our trade expectancy gives us important information we can use to keep our trading on track.
If we were profitable, but are becoming less so, market conditions may have changed or maybe we have become sloppy in implementing the strategy. In either case, we need to correct our behavior, adjust our strategy, or simply step away from the market until conditions become more favorable.
If our trade expectancy is improving, consider why. Did you change something? Inquiring may produce insights that continue to propel you forward.
How I Use Expectancy
Most of my strategies tend to have 50% to 70% win rates, depending on market conditions, with a reward:risk of ratio of 1.5:1 or higher. That means that on average I am aiming to win about 60% of my trades and my gains are bigger than my losses. When day trading forex I may risk 5 pips but will only take the trade if I can reasonably expect to make 8 pips or more. On a futures swing trade I may risk 20 points, but will only take the trade if I reasonably expect to make 40 or 60 points if I win. In this way, the win rate is above 50% and the gains are bigger than the losses.
Taking a trade and knowing you can likely make 1.5, or 2 or 5 times your risk comes from experience and research. It comes from looking at charts and developing strategies. By looking through historical charts, and testing things out in a demo account, we get a sense of how often we will win with a certain strategy, as well as how much we need to risk and how much we can expect to make. Then, as we begin trading, we monitor our statistics and they will alert us if there are any issues.
That is how I like to trade, and how I feel most comfortable. But there is nothing wrong with having a lower win rate, or a higher win rate, or bigger gains or smaller losses. There are infinite ways to trade, and the only thing that matters is that over many trades you have a positive expectancy.