Now that we've discussed some of the factors to entering a trade, and when to exit a trade, we need to spend some time on what kind of results you should expect. This is vital to understand before you start trading a strategy or system.
Traders and system builders need to have a solid and realistic understanding of what they expect in the future, and specifically what returns they expect to produce in terms of profits. I ask traders all the time what kind of returns or draw-downs they are expecting in their account and a surprising number say they have no idea. They want to be profitable, but don't understand how a string of trades may impact overall portfolio value. This kind of trading without planned expectations and rules is a major barrier to success and always leads to losses.
So what's the problem with not knowing what to expect?
Many traders have a propensity for random trading. These kinds of traders seem to be fishing for opportunities. They may take a trade or two from someone else they saw on a forum or newsletter, or they may just be entering trades without a firm stop loss, profit target levels or other risk control procedures in place. They have a tendency to wait and see what happens. Usually, what happens is a gut wrenching period of indecision, loss and frustration. Misunderstanding of trading costs
The second issue these traders deal with is a lack of understanding of system or strategy costs. I usually refer to this as trader myopia or tunnel vision. These traders concentrate on one trade at a time and are not thinking about tomorrow, or next month's trades, and don't understand the costs that can impact results in the long term.
In this lesson we will address those issues, and walk through the process of developing accurate expectancy for the system we have been building so far in the course with.
What is expectancy?
Expectancy is what it sounds like. It helps you understand how winners, losers, gains and losses relate to each other over the long term. This process helps you understand what your trading system profits should be, and helps validate your backtesting.
In this lesson, we will develop expectancy in three steps. First, you will calculate your win- and loss-ratios. Second, you will calculate your reward-to-risk ratio. Finally, you will combine the two numbers into an expectancy ratio. That information will help to understand what you can expect in the future.
Steps for developing expectancy
1. Calculate your win and loss ratio
2. Calculate your reward to risk ratio
3. Combine those two ratios into an expectancy ratio