You’ve probably heard the saying: It’s not whether you win or lose, it’s how you play the game.
It’s a nice sentiment, but it absolutely does not apply to the world of investing. The cold, hard reality is that if you don’t win, and win consistently, then it won’t matter how you’ve been playing the game, because you’ll run out of money to invest, at which point, you won’t be playing at all. All that to say, it really IS whether you win or lose, and a bit more than that, besides. That “bit more” is the topic of this piece.
Now, if you’re new to trading, I already know what you’re thinking. Expectancy doesn’t really matter because you’re already keeping statistics, and you surely don’t need any more, right? After all, you’re tracking your win/loss ratio, and as long as you’re winning more than you’re losing, you should be good to go!
The formula you want to be using
Actually though, simply tracking your win/loss trading ratio gives you an incomplete picture.
The formula you want to be using is this:
EXPECTANCY = (Average Gain x Win %) – (Average Loss x Loss %)
Look at the components of this formula and you’ll begin to see why it’s so important. Your win/loss ratio is in the equation, but it’s only a part of the overall picture. For example, you might have an outstanding win/loss ratio, but still lose money. How is this possible, you ask?
Well, what if all your “wins” were on trades with very small dollar amounts, but your losses were all based on large dollar trades. Overall then, while your win/loss ratio looks GREAT, when you dig more deeply into the numbers, you find that you’re actually losing your shirt. That’s why it’s important to track not just your wins and losses, but the dollar gains and losses associated with those trades.
Some notes and observations on this point. First, you have to understand that you won’t be able to start tracking your Expectancy Rate right from the start. Most experts agree that you need a minimum of thirty or forty trades under your belt before you can start getting anything useful from this measure, and preferably, you’ll want to have a hundred or more trades. The more trades you have to pull data from, the more accurate and reliable this measure becomes.
At the end of the day, what this value really says to you is this: “On any given day, considering my past trading history, I can expect to increase or decrease the value of my trading fund by $X.” Assuming your win % is higher than your loss %, you can expect then, that on most days, you’ll meet or exceed the dollar value revealed by your Expectancy Rate.
Of course, this is merely an average, and unless your loss % is zero (not really possible), there WILL BE some days where you don’t meet your Expectancy.
That’s okay. That’s not a sign that there’s anything wrong, it’s just simply the nature of statistics. By definition, given that this is an average, there are going to be days when your earnings fall below this value.
What if my Expectency is negative?
The other thing to take note of is this: When you begin tracking this value, you may find that your Expectancy is negative. If this is the case, then it should sound alarm bells in your head, and you should suspend your trading activities until you’ve had a chance to overhaul your trading system and parameters, because clearly, something has gone wrong. If you continue to trade under these circumstances, you’re resigning yourself to losing money more days than you’re making money, and obviously, this is not a viable path to long term success. That too, is okay though, because trading doesn’t happen in a vacuum. By tracking these statistics and identifying that there is a problem, you can take steps to correct for it, then try again with a new (and hopefully improved!) system.
As you have no doubt begun to see and understand, there’s a lot more to trading than merely doing your due diligence on a given company, buying stock and waiting to see what happens. Yes, you can trade like that, but you won’t be around in the longer term if you do. Any system you design that relies on hunches or luck is doomed to fail in the longer term. What you need (in addition to careful research before investing in any given company) is a trading plan and system, an exit strategy for every trade, and an understanding of your performance metrics like win/loss ratio and Expectancy. If you’re willing to commit to those things, then odds are excellent that you’ll see your net worth steadily increasing.
Trading isn’t rocket science, but there IS a method to it.
Ignore that methodology at your peril!