There is one critical metric that determines whether or not the system/strategy you are trading is profitable or unprofitable: Expectancy tells you what you can expect to make in return for each trade you place in the market. Expectancy is the formula you use to determine how reliable your system is. You should go back in time and measure all your trades that were winners versus losers. Then determine how profitable your winning trades were versus how much your losing trades lost.
Over 90% of traders are trading with a negative expectancy. They are deceived into thinking that they are going to turn it around or make a run, but the truth is that they are trading a method with a negative expectancy and even if they do go on a lucky run, the end result (long term) will be unprofitable. The good news is that expectancy can be manipulated and even reversed, you just have to change certain things about the way you trade and, as a result, your expectancy can begin to recover.
Expectancy is one of the most important aspects of any trading strategy, however many traders have never heard of this critical concept. Essentially expectancy is the amount you stand to gain, or lose, per dollar of risk. That is to say that expectancy can be positive or negative, known as positive expectancy or negative expectancy, respectively. Expectancy can be formulated mathematically into: Expectancy = (Average Gain * Probability of Gain) – (Average Loss * Probability of Loss).
When experimenting with the 'expectancy formula', traders quickly come to realize that no single set of numbers gives a positive expectancy, but there are an infinite number of sets therefore (in theory) there exists an infinite number of trading systems that could be profitable. The expectancy model is suggesting that even random systems can be profitable if the money management is sound. The expectancy model can also impact on another trading belief; it is possible to develop systems using expectancy and position size as the underpinning foundations where the stop loss is larger than the profit target.
Expectancy, position-sizing and other aspects of money management are far more important than discovering the holy grail entry system or indicator(s). Unfortunately entry techniques are where the vast majority of books and talking heads focus their attention. You could have the greatest stock picking system in the world but unless you take these money management issue into consideration you may not have any money left to trade the system. Having a system that gives you a positive expectancy should be in the forefront of your mind when putting together a trading plan.
