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Trade Expectancy Formula: How to Make Consistent Profits

trade expectancy formula example

The trade expectancy formula is a super important concept for you to grasp before dumping too much money into the trading world. In any kind of trading there are essentially two forces at work: probability, and risk/reward, and people often misuse the terms. I’ve seen people refer to a their strategy as being “high probability” while their actual win rate is really low. So let’s clear this up once and for all:

Probability = how likely it is that your trade will be correct (Example: 50% as in a coin toss)

Risk/Reward = what you risk on the trade divided by what you stand to gain on the trade (Example: risk $1 to make $2 = R/R of 1/2)

Together, these two forces form the “trader’s equation” which is the trade expectancy formula:

(Potential Reward x Win Probability) – (Potential Loss x Loss Probability)

This formula can be used to analyze both individual trades you’re considering taking, and the performance of trading systems in general. The trading system version looks like this:

(Average Win x Win Rate) – (Average Loss x Loss Rate)

In either case, if this number is positive, it’s good. If not, it’s bad.

So in order to take objectively rational trades, you need to make sure every trade you take makes sense in terms of this formula. And you need to occasionally review the ongoing performance of your system by making sure your expectancy remains positive as new trades are added to your trading journal.

In most trading situations you will find the probability of the stock going in your direction hovers around 50%. Author and price action trader Al Brooks says that you should never expect the probability to be any more than 60% or less than 40%, otherwise nobody will be willing to take the other side of the trade. So you should assume the probabilities don’t vary a whole lot in most circumstances.

So what you should actually focus on is looking for asymmetric risk/reward situations. In other words, make sure that you stay out of trades that have a bad risk/reward ratio, and only consider placing trades that have an attractive risk:reward ratio to their potential target.

For instance, if you always look for pullback trades that have at least a 1:2 risk-reward ratio to the prior high, and assume a 50% probability of success, then your trade expectancy formula will look like this:

(2 x 50%) – (1 x 50%)

= 1 – 0.5

= 0.5 expectancy

If you assume a 60% probability, and a 1:2 risk/reward:

(2 x 60%) – (1 x 40%)

= 1.2 – 0.4

= 0.8 expectancy

So higher probability definitely helps. However, if you keep the probability the same as in the first example, and just increase your reward/risk ratio to 3:

(3 x 50%) – (1 x 50%)

= 1.5 – 0.5

= 1.0 expectancy

So risk/reward plays a big role. Also note what the trade expectancy formula looks like for losing system at 40% and 1:1 risk/reward:

(1 x 40%) – (1 x 60%)

= 0.4 – 0.6

= -$0.2 expectancy

The higher the probability of trades you take, the better. But the primary thing you have control over is lowering your risk/reward (or increasing your reward/risk). This can take several forms, but most practically speaking it probably means cutting your losses and letting your winners run!

In dollar terms that you would probably be trading, here’s what it would look like risking $500 on each trade with the aim of making $1000 in profit at a 50% probability of success:

($1000 x 50%) – ($500 x 50%)

= $500 – $250

= $250 expectancy

So in closing, here is a quick reference graph showing which kinds of systems can work and which can’t work based on the trade expectancy formula:

trade expectancy formula
trade expectancy formula – profitable vs. unprofitable trading systems and setups
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New Releases, Site Changes, Transparency

First things first: I’ve been lazy lately when it comes to the site, but mostly because I have an extreme one track mind and my focus lately has been on my own trading instead of maintaining the site. The good news is that over the past week I had a chance to get into gear and clean up some things around here.

I also finally got around to posting the new thinkorswim earnings tool I’ve been working on for anyone that’s interested in that. It comes with 2 columns that show the days until earnings, and the actual date of earnings, and then 2 indicators that show labels with your current charted stock’s earnings date and days until earnings, and highlight the chart’s background when you’re approaching the earnings release date. Here’s a quick example:

Next Earnings Early Warning Indicator Thinkorswim
Next Earnings Early Warning Indicator Thinkorswim

Secondly, I’ve posted some new thinkorswim tutorial videos on the Youtube channel and plan to try to post on there fairly often, so if you’re not subscribed go check out the Youtube channel. While you’re at it, I also have a Twitter, Facebook, and Google Plus page where I sometimes post coupon codes, trades, and product announcements and updates.

One other improvement I’ve been making around here is that I’ve been trying to incorporate my own trade journal into the site in case it can be of any help to any struggling traders out there. Trading is a tough business, and cutting losses is the primary job description, so sometimes my trading journal doesn’t look pretty. Trading is a statistical game where over a large sample of trades, if your system works, you end up with more funds than you started with. Not every trade will work — in fact most won’t, generally — which is why you have to trade with a good risk/reward ratio and a solid trade management plan. I make no claims to trading perfection, and that is why I’m sharing my trading journal … to keep myself honest and transparent, and to show traders that you don’t have to be right all the time to make money, you just have to work an edge consistently. So with that in mind, here are my latest trades, and they will also show up along the sidebar on the blog section of the website…

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How to Install the Vertical Time Lines ThinkScript Indicator for ThinkOrSwim

To check out all my indicators, visit http://easycators.com/product/key-reversal-time-vertical-lines-indicator/

The JR_Timelines indicator for ThinkOrSwim allows you to highlight specific times during the trading day that may be important, such as key reversal times, or lunch time when the big boys leave the scene and volume decreases, etc.

This script lets you add a vertical line, time level, time zone, or time line to your chart.

http://easycators.com/product/key-reversal-time-vertical-lines-indicator/