It felt like Mum’s lawn was cut only 4 weeks ago yet the man who just mowed it charged a lot more than usual. Out of control weeds seemed to have grown alongside price inflation. After checking, it turned out the lawn had been cut 8 weeks ago and mowing man was charging a reasonable rate for a bigger job. Facts not feelings.
Working out profitability based on a formula is a useful fact-based statistic. It reveals how we have been trading in the past and the likelihood of this continuing into the future. Known as Trade Expectancy, the formula is commonly used by traders as well as investors to estimate the expected average profit or loss per trade for the future, based on the trades from the past.
One advantage of the Trade Expectancy formula below is it provides a realistic picture of trading performance based on a more objective measure.
Trade Expectancy = (Win Rate Average Win) - (Loss Rate Average Loss)
Components:
Win Rate: This is the percentage of your trades that end in profit. For example, if you win 60% of your trades, your win rate is 60%.
Average Win: This is the average amount of money you make on a winning trade.
Loss Rate: This is the percentage of your trades that end in a loss. It's simply 100% minus your win rate.
Average Loss: This is the average amount of money you lose on a losing trade.
For demonstration purposes, let’s extract the last 6 months of trading data from a spreadsheet.
WIN RATE
Out of 25 trades 16 were profitable. This means 64% of trades ended in profit. The win rate was 64%.
LOSS RATE
Out of 25 trades 9 were not profitable. This means 36% of all trades ended in a loss. The loss rate was 36%.
AVERAGE WIN
Calculate the average win by tallying total profits and dividing by the number of profitable trades. The final value is the average amount made on a profitable trade.
The average amount of money made on a winning trade in this example was $11520.
AVERAGE LOSS
Calculate the average loss by tallying all the losses then dividing by the number of losing trades. The final value is the average amount lost on a losing trade.
The average amount of money lost on a losing trade in this example was $7100.
Putting these values into the Trade Expectancy calculation:
Win Rate: 64%
Loss Rate: 36%
Average Win: $11520
Average Loss: $7100
Trade Expectancy = (Win Rate Average Win) - (Loss Rate Average Loss)
= (64% x $11520) – (52% x $7100)
= 7372.80-3692
= 3681
Interpretation of Trade Expectancy
A positive trade expectancy indicates, on average, an expectation of making money over time. The higher the number, the better.
A negative trade expectancy indicates, on average, an expectation of losing money over time. You may want to look into adjusting your trading strategy.
A trade expectancy of zero essentially means break even, neither gaining nor losing money in the long run.
In this example, the above result was positive. A trader using their current trading system expects on average to make money over time.
Importance of Trade Expectancy:
Helps you assess your trading strategy.
A positive trade expectancy indicates a profitable strategy, while a negative expectancy suggests you need to adjust your approach.
Provides a realistic picture of your returns.
It goes beyond win rate and considers the size of your wins and losses, offering a more accurate understanding of your potential profits.
Manages risk.
By understanding your average win/loss, you can make informed decisions about risk management and position sizing.
My own positive expectancy confirmed my trading strategy had worked over the last 6 months given the various market conditions. One of the keys to this outcome was keeping trade losses small.
Going forward, the next 6 months look promising though past performance is never a guarantee of future results. Trade expectancy may be impacted by changing market conditions and unforeseen events as well as our fear and greed.
This was first published on Karen Wong’s newsletter World of Trading, a free publication. To receive new posts become a free subscriber and sign up to my Substack.