I received a few questions about expectancy after my article on Expected Value (EV), so I decided to respond with a fresh post (expectancy has always been grouped into the position sizing and expectancy article from last year).

What exactly 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.

• Position Sizing Spreadsheet
• Expectancy Spreadsheet
• Interactive Portfolio Spreadsheet

The same holds true for trading. If your expectancy is positive; you can make money with a certain number of trades within specified periods of time.

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 an example of Expectancy from Dr. Van K. 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 using another basic approach (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 * $2,500) - (0.6 * $625) = $1,000-$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).

Let’s look at the calculation one more time using only percentages:
PW: 40%
AW: 20%
PL: 60%
AL: 5%
(40% * 20%) - (60% * 5%) = 5.00%

What this tells me is that I have a positive expectancy of 5% or $625 per trade from the original $12,500. It doesn’t mean that I will make $625 on every single trade but my system will average a profit of $625 per trade over the course of a year with a combination of winners and losers. I can always make more trades or fewer trades in a year so my total profit will be adjusted accordingly.

Let’s take a look at how EV or expected value can help us become better traders and understand how to measure risk in the market (or life in general). EV can be considered the equivalent of expectancy in the poker world so I think it’s a great read for everyone striving to gain an edge in their trading (or at least understand how an edge can be quantified).

Wikipedia Definition:

In probability theory the expected value (or mathematical expectation, or mean) of a discrete random variable is the sum of the probability of each possible outcome of the experiment multiplied by the outcome value (or payoff). Thus, it represents the average amount one “expects” as the outcome of the random trial when identical odds are repeated many times. Note that the value itself may not be expected in the general sense - the “expected value” itself may be unlikely or even impossible.

In simpler terms:
Expected Value (EV) is the amount of money you can expect to earn over time by making a calculated decision in a specific situation.

The expected value from the roll of an ordinary six-sided die is 3.5 (how do we get here):

Rolling each number has a probability of 1/6.
Multiplying the values with their respective probability gives us 3.5 or:
1 * 1/6 = 1/6
2 * 1/6 = 2/6
3 * 1/6 = 3/6
4 * 1/6 = 4/6
5 * 1/6 = 5/6
6 * 1/6 = 6/6

We get to 3.5 by adding them together:
1/6 + 2/6 + 3/6 + 4/6 + 5/6 + 6/6 = 3.5

What if the die was weighted and we know that the number “6″ has a 50% chance of coming up? We will assume that the other five numbers still have a uniform distribution (equal chance of coming up in regards to each other):

1 * 1/10 = 1/10
2 * 1/10 = 2/10
3 * 1/10 = 3/10
4 * 1/10 = 4/10
5 * 1/10 = 5/10
6 * 1/2 = 3

The expected value from the roll of this weighted die is 4.5.
We can now bet a weighed and non weighted die and know the outcome of our bets and determine the profitability, if any.

Now, let’s pretend we are flipping a coin with two betting scenarios:

Scenario #1:
We bet on the outcome, and receive even-money (we bet $1, we will win $1) on our bet. In this case, if we flip the coin 100 times, we can expect to win 50 times, and expect to lose 50 times. Overall, we win $50, and lose $50, breaking even. We have neither won nor lost any money (and over time, we will not expect to win or lose any money), so our EV is 0.

Scenario #2:
We bet on the outcome, and receive 2:1 odds (we bet $1, we will win $2) on our bet. In this case, if we flip the coin 100 times, we still expect to win 50 times, and expect to lose 50 times. But, the 50 times we win will earn us $100 (50 * $2), and the 50 times we lose we will still only lose $50. So, over 100 flips, our profit will be $50, or an average of $.50 ($50 / 100 flips). Our EV is the average win/loss per flip, or $.50. for every time this flip occurs so we can expect to make $.50.

Like expectancy in trading (a couple of trades will not give you the anticipated outcome of your system), you must understand that these EV outcomes will only take place over time, the long run. Both expectancy and expected value do not apply to short term results (we must make hundreds, if not thousands of trades, flips or rolls to expect the calculated outcome of the game.

I once read this from a poker article:
“ it’s not important to know the exact EV of a situation (in fact, with all the variables and unknown in poker, it’s generally impossible), but it is important to know whether a situation is +EV (i.e., you’ll make money long-term) or –EV (i.e., you’ll lose money long-term). It’s also generally helpful to know if a +EV situation is very +EV (i.e., you’ll make a lot of money long-term) or marginally +EV (i.e., you’ll make a little money long-term).”

I couldn’t have said this better when it comes to making trades for a positive expectancy system. We will never know ALL of the variables in the market so the most important part of a trade is to understand if the risk/reward is positive, very positive or negative.

You will be well on your way to consistent profits by understanding the risk and the potential reward of each and every trade you make. As in poker, dice or coins, a +EV or –EV can be determined even if every variable is not known. The name of the game is to play when you know it is a +EV situation or trade in our case.

I have been hearing a lot about trading systems failing or not working properly over the past few months and it makes me smirk every time. A recent article in SFO Magazine states that traditional technical analysis no longer applies due to program trading or computer algorithms making the trades. The author claims that computers don’t have emotions, therefore they don’t buy based on patterns or make decisions the way a human would. He specifically states that moving averages are now useless. Really? I guess I am screwed. Maybe this has some merit but I don’t buy in to it completely.

Traders and investors always seem to blame their systems and/ or indicators for poor performance when 99% of the time they should be looking in the mirror. They need to look in-between the ears to locate the problem. As I have explained in the past, the system is not the Holy Grail of Trading. I wrote a post last year that was missed by many since it was written shortly after the fourth of July holiday. Now seems to be the time to discuss this topic, more so than last summer.

• What do you think?
• What is your Holy Grail of Trading?
• Has your system stopped working or have you disconnected with the changing market environment?

Original Post:
Do you have a wonderful trading system, one that consistently makes you money? You probably believe that you have found your holy grail but this couldn’t be further from the truth. Your system has very little to do with consistent profitability in the markets.

I often here amateur investors talk about that the “best way” or “only way” to invest and argue why their way is better than everyone else’s. The passion and energy exuded by these novice investors is wonderful but they are missing the point completely. No one can say that options are better than stocks, commodities are better than options or forex is better than everything, etc… Each investor develops a system that is suited to their own personal character traits and they use a vehicle (stocks, options, forex, commodities, real estate, etc…) that can help them reach their goals.

Investors also debate systems within a market such as: trend trading, swing trading, scalping, shorting, day trading, buy and hold, fundamental trading, technical trading, Elliot wave theory, moving average crossovers, etc… They all work if the “person” understands the holy grail of trading. And that is being able to understand YOU and how your mind works.

However, it is not the system that makes one successful. It is YOU that makes the system work properly. What do I mean? Each individual must master their own personal psychological impacts on their trading results. You must work on YOU to become consistently successful! I recommend reading The Disciplined Trader by Mark Douglas if you would like to understand the psychological trader in you.

To say that one system or vehicle is the “way to go” is ignorant.

Read more »

I went back and tried to pick out the best 20 posts that new readers can start with when coming to this website. I will be permanently placing them at the top right sidebar.

Top 20 chrisperruna.com Posts

• Listen to My Audio Interview
• My Interview at StockTickr
• Position Sizing and Expectancy
• The Holy Grail of Trading: It’s not your System
• How to Create a Successful Stock Watch List
• My CANSLIM Screening and Buying Strategy
• Fundamental Screens and Scans
• CAN SLIM Breakdown
• Understand the ‘M’ in CANSLIM
• Paper Trading: Nothing to Lose, Nothing to Learn
• Focus on Decisions, Not Outcomes
• Could you Trade Full Time?
• Position Size to Determine How Many Shares to Buy
• Trading Mistakes: Avoid at all Costs
• How to Calculate a Stock’s Pivot Point
• Do Not use Fundamental Analysis Alone!
• How to Short a Stock
• Learn to Focus when Investing
• Markets are not Efficient
• Point and Figure Charts

Let me know if I am missed an article that you believe should be on this list.

Six Secrets of Successful Bettors: Winning Insights into Playing the Horses, a book I randomly stumbled upon while walking through Barnes and Noble this weekend. Now, I haven’t read the book and probably won’t but the table of contents read like it was coming from the trading world (the two entities are very similar when run like a business). The six secrets discussed along with the titles of the chapters would be perfectly sufficient for an author writing a new book on trading.

The six secrets are:

• Act as an entrepreneur not a gambler
• Make the best use of available resources
• Only bet when there is a significant edge
• Manage bankroll effectively to maximize advantage
• Know how to handicap yourself using effective record-keeping
• Effectively handle emotions as well as money

Chapter Titles:

• Chapter 1 - A Hard Way to Make An Easy Living
• Chapter 2 - The Information Edge
• Chapter 3 - The Never-Ending Quest for Value
• Chapter 4 - If I Only Knew How to Bet…
• Chapter 5 - Woulda… Coulda… Shoulda… Doesn’t Get it Done
• Chapter 6 - It’s One Long Game
• Chapter 7 - The Road Ahead: Issues Facing the Game

Charter six, It’s One Long Game, started with the title phrase of this blog post:
Focus on Decisions, Not Outcomes.

I quickly reminded myself how true this is when trading as too many investors focus on the short term results or the money won and lost in each trade rather than the net result.

The idea of the game is to make the right choices and understand that some of those choices will turn out to be losers. Losers are part of the game and must not affect you emotionally as long as the decision was correct. You must study, analyze and focus on your decisions, not on the amount of money won or lost on each individual trade. As long as your decisions are correct and consistent, you will be a winner over the long term.

Chapter six has been appropriately titled to translate to the trading world:
It’s One Long Game – GET USED TO IT!

On another note, I also started to read a book titled The Wolf of Wall Street while at Barnes and Noble and it had an interesting start but turned into a complete story about a scum bag from the late 1980’s and early 1990’s. I can only imagine what’s going on in the sleazy Hedge Funds of today. I put it down after I realized the guy was only interested in talking about Quaaludes, cocaine and ridiculous drinking. He scammed people out of tens of millions of dollars, cheated on multiple wives, admits he lied for a living and went to prison (he sounds very proud of the accomplishments mentioned). I feel bad for his children. He was in it for the short game – get rich quick! Loser is all I can say.