Why expectancy is an important part of trading How to calculate it and how to use it

Expectancy along with position sizing are probably the two most important factors in trading/investing success. Sadly most people have never even heard of the concept. Out of the many books on trading only a few even touch on any aspect of money management. Only one of those handful of books discussed expectancy. In simple terms, expectancy is the average amount you can expect to win (or lose) per dollar at risk. Here's the formula for expectancy: Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss) As an example let's say that a trader has a system that produces winning trades 30% of the time. That trader's average winning trade nets 10% while losing trades lose 3%. So if he were trading $10,000 positions his expectancy would be: (0.3 * $1,000) - (0.7 * $300) = $90 So even though that system produces losing trades 70% of the time the expectancy is still positive and thus the trader can make money over time. You can also see how you could have a system that produces winning trades the majority of the time but would have a negative expectancy if the average loss was larger than the average win: (0.6 * $400) - (0.4 * $650) = -$20 In fact, you could come up with any number of scenarios that would give you a positive, or negative, expectancy. The interesting thing is that most of us would feel better with a system that produced more winning trades than losers. The vast majority of people would have a lot of trouble with the first system above because of our natural tendency to want to be right all of the time. Yet we can see just by those two examples that the percentage of winning trades is not the most important factor in building a system. James Ramsay is a Private Trader and the developer of OTrader Investment Portfolio Management Software. Get a free 20 day trial and get your position sizing and trade management under control. portfolio-management-software.otrader.com.au