When you're choosing a strategy to trade, one the most important thing to consider is whether it has a positive expectation, ie does it make money in the long run?
What Is Positive Expectancy
Trading is a game for the long run, so you are looking at what the results for the trading strategy over a long period of time, and this could be hundreds or even thousands of trades.
A trading strategy is said to have a positive expectation if it makes money on average in the long run. It is a statistical expression on how much money a strategy will make (in absolute or percentage terms) on average with each trade.
What do I need to calculate this?
You will need:
– Percentage chance of winner
– Percentage chance of loser
– Average winner
– Average loser
If you have a good trading strategy you will know all of these pieces of information. Any good trader knows these bits of information, so if you are thinking of purchasing a strategy or are developing one, these are the basic pieces of information you will need to know to decide wherever the strategy will be a winner in the long run.
How do I calculate expectation?
This is the easy bit. Follow the formula below:
(% Chance of Success) x Average winner – (% Chance of loser) x Average loser
The figure you get is an expression of how much money the strategy will make per trade in the long run.
This figure is saying that on average, I will make x amount of money, and I will lose y amount of money on average. So the difference is the amount of profit (or loss) that I will make in the long run.
If expectation is above zero, you can expect to make money in the long run. If it is below zero you can expect to lose money over time.
Even if you have been trying out a strategy and it has made you a lot of money over three or four trades, if these figures end up negative, you must NOT trade that strategy as it will lose you money in the long run.
When choosing a strategy to trade, look for successful traders who are using the strategy and ask them wherever they have information above. Good record keeping is crucial to success in trading so any successful trader will have an accurate log of their trades and will be able to calculate the figures.
Beware of any strategy for sale that does not have this information easily to hand.
What's a good expectation?
If you can find a strategy that makes on average 1% per trade, then it is likely that it's a good strategy. The most important factor is that the expectation is a positive number
Source by Mark S Tan