Your Trading System's Expectancy

Expectancy is the term used by Van Tharp (see books) to describe the profitability of your trading system. According to Van Tharp, it's the ‘mean R-multiple of your trading system’. You may recall from our discussion on Position Sizing that ‘R’ is used to denote the amount risked per trade. If your average amount risked, your ‘R’, over many, many trades, is $500 and your average profit per trade is $100 (don’t for get to deduct your brokerage costs), then you have a system with an R-multiple of 0.2.

How large should your expectancy be? You would imagine the answer would be ‘as large as possible’. However, consider the situation if your trading system has an R-multiple of 2.0, but it only throws up one trade a year – don’t give up your day job for this! It would obviously be preferable to have a system with an expectancy of 0.2 which gives you 100 trades a year. Therefore, you also need to take into account how many opportunities to trade occur in a year with your system.

How do you increase your expectancy, your average R-multiple? You can:

·         increase your Win Rate, i.e. the percentage of winning trades to losing trades; or

·         increase the Average Win Size; or

·         reduce the Average Loss Size; or

·         reduce the buy/sell brokerage costs

However, as you test the various possibilities for your system, you will discover the interrelationships that exist between these items. For instance, tightening your Stop Loss will reduce your Average Loss Size, but it will also reduce your Average Win Rate as you'll be stopped out more often. Only by backtesting the various permutations can you discover which will be the most profitable for you.