To Start: Here is the link to the Expectancy Calculator in Excel
Feel free to save it to your computer!

Use the expectancy calculator with my Position Sizing Calculator

I have been watching as a several people on a forum discuss, argue and lend their ideas about entry techniques. They are going crazy over what the proper entry should be and why one chart pattern is better than the other. One person has even said how they purchased massive amounts of software to help them enter the market. Now don’t get me wrong, I always use techniques to get me in the market but I understand that this is the least important factor weighing on an investor’s overall success. I use technical analysis every day and I study patterns that allow me to enter with the ideal buy point (what I believe to be the ideal entry) but I know that strong up-trending stocks give me just as good a chance to make money as stocks breaking out of a cup with handle pattern. I am one that makes my living buying stocks making new highs so I can basically prove that the random entry strategy does work as long as strong money management and exit strategies exists.

By reviewing my personal trades and the coverage of dozens of stocks on the MSW Index over the past two years, I can tell you that my system with the highest expectancy is buying fundamentally sound stocks that are making new highs on above average volume. Where do I find these fundamentally sound stocks? I use multiple computerized screeners that filter out stocks with increasing earnings, high EPS ratings and increasing relative strength ratings. Once I find these stocks, I narrow them down using my own eyes by performing technical analysis. The process is simple as I am basically looking for stocks making new highs with decent to strong fundamental numbers. The process is almost random. To tell you the truth, I could probably narrow down my buy candidates each week to a list of 20 and throw darts at ten stocks to buy the following week and still have a profitable year because I do use position sizing and strict sell rules. Think I am crazy: think again as I explain what expectancy is.

I responded on the forum by saying: Entering at the right time is important and it can lower your risk and increase your overall expectancy but money management and exits are much more important than entry.

Studies have been done between random entry systems and specific systems that use entries based off of chart patterns with amazing results. The random entry system typically outperforms the structured entry system when it uses money management (position sizing techniques) and a strong exit strategy (assuming that the structured system doesn’t employ money management tools).

I love CANSLIM and O’Neil but the entry is not the most important aspect you should be focusing on, it is money management and exits. Most people don’t want to hear this and that is why so many “entry based systems” sell so well over the years. How many of those systems actually make their users money? CANSLIM does use a 7%-10% sell stop rule but it ignores position sizing and never explains the probabilities of the system when implemented in certain ways.

As I said, I make money using a system based from CANSLIM (an entry system) but it is heavily balanced with strong money management techniques and a strong exit strategy.

So what is expectancy?

Expectancy tells you what you can expect to make (win or lose) for every dollar risked. Casinos make money because the expectancy of every one of their games is in their favor. Play long enough and you are expected to lose and they are expected to win because the “odds” are in their favor. Most games at a casino are completed in a short period of time so they can increase their odds of winning. The same holds true for investing. If your expectancy is positive; you can make more money with multiple trades in shorter periods of time. If you told me this ten years ago, I would strongly disagree based solely on beliefs. Now with experience, I continue to move down the path to more frequent trading and a structured system that is run like a business. I now have massive amounts of data based on real trading that I have performed over the past several years.

Expectancy is your profit percentage per win multiplied by your win rate minus your loss percentage per loss multiplied by your loss rate. I will use examples from Trader Mike’s: Trading 101: Expectancy and Van Tharp’s Book: Trade your way to Financial Freedom:

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)

Expectancy = (PW*AW) less (PL*AL)
PW is the probability of winning and PL is the probability of losing.
AW is the average gain (win) and AL is the average loss

So let’s do an example (assume $12,500 per position, a $100,000 portfolio using 1% equity risk):
If my trades are successful 40% of the time and I realize an average profit of 20% but I lose an average of 5%, my expectancy is $625 per trade.

(0.4 * $3,125) - (0.6 * $625) = $625

$1,250-$375 = $625

I lose 60% of the time yet I show a profit of $625 per trade. If I have a system that produces 65 trades per year, I would realize an annual gain of $40,625 (hypothetical scenario). A 40% gain on the original $100,000 (minus all commissions, fees, taxes and compounding).

Trader Mike offers an example geared towards a day trader:
“As an example let’s say that a trader has a system that produces winning trades 30% of the time. That trader’s average winning trade nets 10% while losing trades lose 3%. So if he were trading $10,000 positions his expectancy would be:
(0.3 * $1,000) - (0.7 * $300) = $90

So even though that system produces losing trades 70% of the time the expectancy is still positive and thus the trader can make money over time. You can also see how you could have a system that produces winning trades the majority of the time but would have a negative expectancy if the average loss was larger than the average win:
(0.6 * $400) - (0.4 * $650) = -$20

In fact, you could come up with any number of scenarios that would give you a positive, or negative, expectancy. The interesting thing is that most of us would feel better with a system that produced more winning trades than losers. The vast majority of people would have a lot of trouble with the first system above because of our natural tendency to want to be right all of the time. Yet we can see just by those two examples that the percentage of winning trades is not the most important factor in building a system. ” - Trader Mike

Most traders look for three major factors when developing a system:
The right odds or positive expectancy
Multiple trades (opportunity)
Shorter holding periods to compound the profits

Let’s look at the calculation one more time using only percentages:
PW: 48%
AW: 10%
PL: 52%
AL: 4%

(48% * 10%) - (52% * 4%) = 2.72%

Using a trade size of $12,500, each trade would return you $340 or 2.72% (profit). Let’s say this system gives you 200 trades per year; your result would be a $68,000 profit with only 1% of equity risked or $12,500 on $100,000. This doesn’t include compounding profits with each successful trade.

A positive expectancy can come from an unlimited amount of numbers or scenarios. You could have a system that produces winners 30%, 50% or 80% of the time and each system could be positive or negative based on PW, AW, PL & AL. An infinite number of trading systems and/or number combinations can be used to find a positive expectancy system.

The one thing I have realized over the past few years as my account grows is the fact that opportunity must exist to make money with a positive expectancy system. Think of the casino; the more you play, they more they win. The same is true for trading; the more you play with a positive expectancy system, the more your odds are for that system to return the expected number.

I have been tailoring my system to produce more trades and opportunity so I can take full advantage of the mathematical odds. As many of you know, I graduated as an architectural engineer and love numbers since my courses were based in advanced math and physics. Numbers don’t lie; I love to play poker because I understand the odds so I am typically successful over long stretches of time at the table because I have the emotional stability to only jam the pot when the odds are in my favor. Like stocks, I do my best to let go of losing hands and losing positions (sometimes I follow a committed hand in poker or a committed position with stocks but the odds are no longer in my favor and more times than not, I lose the hand or settle for my maximum stop). I am attracted to games with numbers and odds and the stock market is the best game in the world (in my opinion). Poker is a close second.

I want you to think about one more example (provided from ARB Trading)

“You will be more profitable with $100,000 that you could “turn” 250 times per year, than $500,000 that was tied up in one trade for 12 months. As an example, let’s say we have one trade and that trade yielded a 50% return. You just had a great year - a $250,000 profit.

On the other hand, say you had $100,000 for stock purchases, and your expectancy was only 1.2% per trade but you turned over your stocks 250 times in the same year. This method ends up generating $300,000 for the year, and that assumes you never increase the position size as the equity grows. You just had a better year. And it is easier to get 1.2% per trade than 50%.” - ARB Trading

Piranha

Investors sit patiently or anxiously in some cases ahead of the Federal Reserve’s next move on interest rates, to be announced today. The DOW is within striking distance of its all-time high of 11,722.98, reached on January 14, 2000. Crude oil is sitting slightly above $70 (near major support – also known as the prior resistance line). Gold is trading slightly above $700 an ounce, its highest level since 1980. With the stock market, crude oil, gold (and other commodities) all trading at or near highs, we know one of these areas must bust or give way to the others. I don’t have a crystal ball so I can’t tell you which area will fall first or the hardest but I have plans to protect my capital against any major decline or collapse. Take a look at the 10-year chart of the DOW and see how close we are to making a new all-time high. I am waiting for the Fed announcement later in the day to see how I will continue to play positions going forward.

Piranha

Hansen Natural (HANS) was up over 16% today to close above $176 (an all-time high) after solid earnings and an announcement stating that the company will form a distribution agreement with Anheuser-Busch. I have written about the stock several dozens times on the MSW screens and at least a dozen times on this blog in 2006. I have personally owned the stock on two separate occasions (buying at levels that some investors thought were crazy – too high or extended). I took my first position above $66 in May 2005, even though the stock was up several hundred percent during the prior year. I sold the stock later that summer for a 50% gain due to my objective being hit (looking for a $60-$100 run).

I continued to follow the stock and watched as it built a base after a stock split. As soon as HANS broke out of the sideways consolidation, I jumped back in last November. I held the stock once again with the exact objective as I had the first time: another $60-$100 run. I was awarded with another 50%+ gain as the stock completed its second $60-$100 run in one year. After selling the stock due to another consolidation near $100, I removed it from the MSW index shortly thereafter.

I continued to cover the stock on an honorable mention list and wrote about it several times on this blog over the past two to three months. Looking back, I see that I sold too early but my objective was met so I can’t be greedy. Maybe I should have looked for a third entry into the stock as it is now worth $175 per share or $360 (pre-split adjusted from my original purchase last May). I left $75 on the table and another 75% if I bought back in above $100. If I held the stock without jumping in and out, I would now have a long term capital gain of 430%. It’s all hindsight now but the main point of this post is the fact that great stocks and highly priced stocks can go higher. HANS is now up over 1,800% since its initial breakout in May 2004. You read that right: 1,800% in two years. I managed to grab a compounded gain of slightly more than 100% and I am very happy but I think of what could have been! As soon as that thought creeps into my mind, I trash it because it’s an emotion detrimental to my overall plan.

Below is the actual analysis I gave when I added the stock to the MSW Index on May 7, 2005 and then again on November 11, 2005. HANS lived on the MSW Index for about 20 weeks and has been the number one stock on my honorable mention list for the past two months. HANS is a superstar in my eyes and I am extremely proud that I was part of its stock market history.

11/5/05:
HANS – 57.63, With the breakout from the sideways movement over the past several months, HANS is back on the weekly screens with an up-trend that is still intact going back several years using the 200-d m.a. as support – AMAZING chart.

Hansen Natural (HANS) is back on the MSW weekly screens for the first time since August 6, 2005. The stock debuted the first time at a pre-split adjusted $66.56 and lasted for 13 consecutive weeks until its final screen at $91.46 on August 6, 2005. The stock reached a weekly high of $97 while on the MSW screens and basically completed a $60-$100 run. Since August, the stock split and has been correcting in a sideways pattern. The breakout this week made us take notice on a daily screen and after further analysis, we felt is was a good idea to bring back to the weekly screens. I will be very interested to see if the stock can make another $60-$100 run, that would be a remarkable feat to accomplish two times in one calendar year.

5/7/05:
HANS – 33.28, (pre-split adjusted $66.56), we profiled the stock on the case study this week with major support down near $53. The stock boasts one of the strongest RS lines in 2004 and 2005.

I leave you with one question: Is HANS priced high or low in your opinion? Many thought is was overpriced and done last May at $66 (split adjusted $33).

Piranha

Two MSW Index stocks have reported since the close of the market yesterday and we are batting .500 (one right and one wrong but I can say that we could have anticipated the one that went wrong).

Las Vegas Sands (LVS), $71.34, was up over 7% in early afternoon trading as first-quarter earnings jumped to $121.8 million, or 34 cents per share, from $7.1 million, or 2 cents per share, in the prior-year period. The year-ago results were significantly impacted by an $86.3 million loss on the early retirement of debt. Adjusted net income rose to $134.8 million, or 38 cents per share, compared to $103.1 million, or 29 cents per share, during the same period last year. LVS has now gained 26% on the MSW Index since April 1, 2006 – another successful trade.

Here is what I had to say on last Saturday’s MSW Index:
4/29/06
LVS – 64.81, Earnings come out this Thursday so be ready for that up or down swing. If numbers keep in-line with past reports, I expect the stock to beat expectations and move higher (a hard stop is advisable to protect from bad news).

This is what I wrote when the stock was added to the Index last month:
4/1/06
LVS – 56.66, The stock has been screened many times (daily) over the past several weeks so I have decided to add it after further research. The stock comes to the Index as a possible $60-$100 candidate over the next twelve months. The strong 8% move this past week gives us the feeling that the young stock is ready to move. I am also looking at the September call options (in the money calls).

By the way, these in-the-money calls were trading at $7 last month (they are trading above $17 today). A $700 contract would be trading at $1,700 in one month, a 143% gain.

LoJack (LOJN) shares are down over 11% in mid afternoon trading as the maker of vehicle-tracking devices posted an 11 percent jump in first-quarter profit, but the company’s shares are down due to concerns the company is lowering prices too aggressively. The drop should not come as a surprise to MSW members as we highlighted trouble in the chart on last Saturday’s weekly screen:

4/29/06
LOJN – 22.11, The stock is in trouble. This is one of the first 200-d m.a. plays that have violated the long term support line without making that anticipated “pop”. Volume is low so we will keep it here until May 5 – earnings day. Place a hard stop to protect against bad news. If good news hits the wire, the stock will fly! Rating: Hold

We added the stock back on March 18, 2006 but it has not materialized above the 200-d moving average as other MSW stocks have.

3/18/06
LOJN – 22.53, LoJack is another candidate added this week based on long term support at the 200-d m.a. with a trend buy opportunity right now at the current price. Buy and set a sell stop about 7-10% below the purchase price (slightly below the 200-d m.a.)

Some stocks work, some don’t and this is why we use strict money management rules to push the odds in our favor. If you bought both of these stocks, you would be stopped out of LOJN for a small loss and would be sitting tight with a solid gain in LVS. Since LVS is now above a 20% gain, you should start to think about placing a hard stop to guarantee profits if it were to reverse for some reason. I am still looking for the $60-$100 run for LVS, a move that would give the stock a 60%+ gain over time.

It’s not about winning or losing, it’s about playing the odds! Strong poker players would truly understand this philosophy.

Piranha

MSW Member Question:

I had a question about position sizing. Let’s say that you have a stock in your portfolio that is up 30% then forms a base/consolidates to a moving average, and you want to add to this position. How would you go about doing this? I know that you’re supposed to add less shares when pyramiding up, but would this be considered a second position according to position sizing techniques? Or would you only initially add 2/3 to a position when the stock breaks out then the additional 1/3 if it pulls back?
Thanks

My Answer:

There are a few ways that I have approached this situation. Some of you may agree and some of you may disagree with the way I pyramid or scale my positions when they are in confirmed up-trends after my original entry. When the market is weak and the NH-NL ratio is not confirming a bull market such as 2005 and 2006, I am cautious when I enter a position making a new high. Hypothetically speaking, I will use a $100,000 portfolio and round numbers to keep the examples simple although the CBG position explained in detail is based on a true position.

If I start to research a stock and feel it will travel from $60 to $100, I will determine the maximum position I can assume from a simple position sizing calculation. If I determine I can handle an 8% drop, I am allowed to purchase 208 shares at $60 per share (I’ll typically round it off to 200 shares in this situation). My position size will be $12,500 with a maximum drawdown risk of $1,000 or 1% of my entire portfolio. My stop will be located at $55.20 or slightly beneath a specific support area that is within 8% of my purchase price. If the stock is breaking out of a specific pattern such as a cup with handle, I will buy half my position at the time of breakout and the other half after the trend is confirmed several days later.

If the stock is in a solid up-trend and not in a recognizable pattern, I will typically purchase 2/3rd of the position when I see the opportunity and then follow up with the remaining 1/3rd of the position at the time of the next pullback (only after the stock reaches a minimum gain of 25%).

Other times, when the market is acting healthy and the NH-NL ratio is strong, I will initiate the entire position based on my original 1% position sizing model and reassess the situation at a later date. Using a recent example, I added shares to CBG when it consolidated in the $40’s and then readjusted my position sizing model to 1.5% (the math can become tricky at this point since the price has changed and my portfolio value is different). I have never gotten into this much detail in a simple blog post but I guess now is better than ever. This method is my own so you will not find it anywhere else and it may or may not appeal to everyone.

The following is a true example using actual stock prices but the portfolio size has been altered to keep the calculations simple and to keep my own activity discreet.

When I first purchased CBG, I took on the entire 1% portfolio risk and wasn’t sure if I would ever add shares in the future (this wasn’t my concern at the time). I liked the stock and thought the 15 week pattern that preceded my buy was picture perfect (especially since the correction was due after the prior up-trend from the IPO date). I placed a market order on June 1, 2005 at $38.97 for the entire risk amount of 1%. The stock was already under coverage on the MSW Index since May 21, 2005 at $37.20 but I was looking for a break above $39. I used the calculation of $39 which gave me the purchasing power of $12,500 or 321 shares (my order was filled for 320 shares at $38.97 = $12,470). After I placed the position, the stock immediately reversed but I stayed put as it didn’t violate any sell signals and then watched as it quickly advanced into the $40 range and approached $50. The stock consolidated over the next three months as I held the position and started to cover it more heavily on the MSW Index with a new purchase price of $50. The resistance line was touched several times so I decided that I was going to add shares if the stock broke-out above $50 with confirming volume.

As it turns out, I did add shares when the stock started to form the obvious consolidation during the fall of 2005. I added shares on November 2, 2005 at $52.68 (a little higher than I wanted but it was an extremely powerful move that day). The stock hesitated slightly over the next several days but never violated the new support line of $50. Within six weeks the stock moved towards $60 per share and I felt very comfortable. So, how many shares did I buy and how did I determine the size of my additional position?

When pyramiding up, I have always been taught by my father to take on a smaller position than the original purchase. In this case, my portfolio had grown by about 10% since the summer so I decided that I could take on another 0.5% risk in CBG (a total risk of 1.5% - my maximum risk in any one stock caps at 2% of my entire portfolio). When running the new calculation, I had a portfolio size of $110,000 (hypothetical value) with a 1.5% risk factor or $1,650 risk on the entire position.

I used a price of $50 with a risk factor of 0.5% (half of 1%) with a stop of 8% (typical for my calculations) which gave me the purchasing power of $6,875 or 138 shares. I bought an additional 130 shares and added them to my original position of 320 shares for a total of 450 shares and a total cost of $19,318.80 (minus all fees, etc…). Now, take a look at how this works (it doesn’t work perfectly every time but this time I kept the numbers round): Using the position sizing calculator; plug in a portfolio value of $110,000, a risk of 1.5%, stop loss of 8% and an average cost basis of $45.83 (($38.97+$52.68)/2). What do you get? Amazing: a position size of $20,625 or 450 shares. I currently hold 450 shares with a dollar value slightly lower ($19,318.80) than the maximum calculation in this equation.

The support line is $50 but the stock went on to maintain the 50-day moving average as the true support line heading into 2006. I have not sold one share in this company as I approach one year of holding the stock from the original date of purchase. I will not base my sell on anything but my stop which currently resides slightly below the 50-day moving average. I have a tremendous gain in this stock and I owe it to two things: CANSLIM for finding the actual stock (strong earnings and a recognizable pattern setup) and position sizing for giving me the right amount of shares to purchase. By using the moving average and a retracement stop calculation, I know the exact location to take my profit. Also note that I will most likely scale out of the position if it starts to consolidate in a new range. This is a topic for another day! I always start with a 1% risk factor but will raise my risk factor to 1.5% or even 2% in rare situations when things are working out and I am placing good money after a profitable trade. Again, this is my own personal method so I advise that each individual use what works best for their own portfolio and test several scenarios.

I am open to questions if anyone has them!
Piranha