If you are in forex trading or any other form of trading, you need to understand that money management is very essential. Along with that, keeping a stronghold on your trading account is important and for that controlling the loss is a big component. A lot of traders take a risk of one or two percent to manage the loss.
What is Expectancy in Trading?
Trading expectancy is a calculation that presents what is the profit for each trade placed – how many trades are won with the average loss on losing trades and the average gain on winning trades. The main question is do traders have a positive outcome on average when dividing total profits by total trades.
But along with that, having a money management algorithm in place helps in increasing your capabilities of setting trading strategies. There are two main parts of this money management that include expectancy and risk. Expectancy in forex trading means the average expected amount you would gain or lose for a trade. It is a kind of risk to reward ratio.
After implementing this, you would have a better outlook on the market. We understand that this topic can be a little heavy, and that is totally alright to take your time to comprehend the information. Eventually, with practice, you would ace it with ease. To trade forex, you also need to have basic knowledge of probability concepts, but that’s all, we promise!
As stated earlier, experience in general terms means how much you expect to earn for the risk you are willing to take in a trade. For example, for taking a risk of $1, if you earn, $2, then your expectancy is 2 times. Now, if you are expecting to earn $0.60, your experience would be 0.6 times that of your risk. Now, if you end up losing $0.50, then your expectancy would be -0.5. Just remember that any expectancy above 0, is profit and below is a loss.
You can also calculate your expectancy rate by adding your average risk or reward for a trading series. Though it is better to understand the concept of R multiples before getting into such complexities.
Expectancy Ratio Formula Example
100 winning trades: 33.33% winning trades
200 losing trades: 66.66% losing trades
Risk reward: $400 average winning trade/ $100 average losing trade = 4
Now we can calculate the expectancy ratio:
(Reward to Risk ratio x win ratio) – Loss ratio = Expectancy Ratio
4 * 0.3333 – 0.6666 = 0.66
What are R Multiples?
R multiples are the way that helps in deciding the initial level of risk for trade in terms of risk or reward. For example, in the forex market, if you have 40 pips stop loss, and have the risk of $5 pips, then if the situations turn opposite you, you would lose $200. This $200 is the initial loss also known as 1R risk. R stands for risk here.
Now, going further, we can define the risk by using R, like 1R, 2R, etc. instead of using pips or dollars. I.e. you are taking a trade worth $50 gain and $25 loss, you would make double the risk you take, which would be 2R. but if you lose $25, you would have a loss of 1R.
Traders implementing R multiples generally talk in this manner, “I earned 3R yesterday, and lost 1R today.” “This trade has the potential of 4R.”
Calculating the expectancy Formula in Trading
You now have the knowledge of R multiples, so now let’s get into the expectancy formula. These are the two main steps.
- Add the total R values of your total traded
- Divide the total by the no. of trades you have taken.
Following is the expectancy formula:
Expectancy = Total R / Number of Trades
Let us take an example. If you have taken 20 traded in total and have made 40R in total, according to the equation,
40R / 20 = 2
You have an expectancy of 2 here.
Money Management and Entry/Exit Points
A trader can develop his own money management tool to decide the perfect time of entering and exiting the trade. You can also develop these rules without considering your entry or exit points. You can consider the following for the same.
- The entry and exit strategy can generate an average number of R multiples with the passing time.
- A money management or position sizing approach that can be applied over the entry and exit strategy.
Your trading performance would depend on your total performance minus the trading mistakes you occur. Let us simplify this with an example.
As per Van Tharp, 90 percent of the reason for the variance in the performance of any professional trader depends on position sizing. These are all the variations, but the basics are the same.
- Each marble that is pulled out from the bag is denoted as a trade-in R multiple, like you may gain 5R or lose 1R.
- Each person has the same starting capital mount, and you have to take a certain amount of risk to pull a marble from the bag.
- Real money is involved in each game that is up to $1200 at a certain point.
- Each stimulation has at least around 30 pulls and up to 27 participants in each game. Everyone has the exact same trade. The system has more losing trades, and a few large winning trades.
So, in this case, each pull of marble from the bag is called a trade. that is your entry and exit. The only control you have here is your position sizing.
After the end of each game, everyone has different equity, and the variations between that are also huge and vary from being bankrupt to a million-dollar profit.
This marble bag game states the importance of position sizing and how it has to be applied over the entry and exit points.
Money Management and Risk
You have to take a risk if you want to trade and apply money management. Your return would be exact of what you take the risk. After understanding the expectancy rates and R multiples, the next big decision you should be taking is about position sizing. That’s the reason why some investors are happy with their ten or fifteen percent a year returns, while some traders prefer making millions from their twenty to thirty thousand.
In the end, you should trade as per your preferences and choose the position of your trade as per the risk you are willing to take.
The concept of expectancy rate is a little complicated, but it is an important decision-making component that helps you manage your risk and return. Take your time and start with 1R risk, you can always alter it as you learn the efficiency.
We have learned various things in this article including the R multiples, how to calculate the expectancy rates, money management over the entry and exit points, along the nature of risk. By taking baby steps, you can develop your own money management approach, and build a consistent career in trading. All the best!