There are two things a trade must to if he or she wants to be profitable… Develop and edge and position size correctly.
The latter is derivative of a trader’s ability to managing risk; the former made up of two metrics, expectancy and R-multiple.
In my last post titled An In-Depth Guide to Managing Your Trading Emotions I referenced the four trading fears and 8 cognitive biases. The expectancy and R-multiple calculations can help build confidence in your trading and a sound foundation for branching out to other markets.
Life is made up of a series of random occurrences. Understanding probabilities can help to balance out the ups and downs and emotional strain that comes with it.
The 5 Phases to a Profitable Trading Strategy
The beginning stages of a profitable trading strategy are made up of 5 fundamental phases, they are as follows…
1. Develop an Edge
2. Test Your Edge
3. Gather Trade Data (50-100+ trades to start)
4. Compute the data and review the numbers
5. If the numbers make sense, move forward
As you’re probably heard me talk about numerous times the relationship between trading and poker. This concept is made incredibly clear in the book Trade Like a Casino by Richard Weissman.
The most profitable realization to a trader is when they can begin to view each occurrence in their trading (and their life for that matter) as a random series of events. It’s only the outcome over a larger statistical set that make sense. You must zoom out and see the forest amongst the trees.
The R multiple is easy to remember, R stands for risk. Your initial risk on the position is equal to 1R. Go back through your trades and take a look at them in terms of R.
For example, if you risked 6 ticks on a position and the resulting outcome was a profit of 12 ticks, you would yield a gain of 2R.
If however, your risk 6 ticks and your trade results with a loss of -3 ticks you would yield a loss of 0.5R.
Looking at your trades in terms of R gives a much greater insight into the risk-to-reward that your assuming when placing your trades. Another way to look at the risk-to-reward is to analyze your trades using your average winner / average loser. This ratio is the first step in calculating your expectancy.
More on using an applying the R-Multiple can be found in the Trading Instruction Membership.
Trading Expectancy Calculator
How much can you expect to make per trade? This is what the trading expectancy equation tells us. This is the formula I use for calculating trading expectancy…
(Average Winner x Win Rate) – (Average Loser x Loss Rate)
A small change in any one of the four factors (average winner, win rate, average loser, or loss rate) can have a huge impact on your results after 100 trades.
Greg Thurman has two fantastic tools in his Trading Journal Spreadsheets package, the Expectancy Calculator and Drawdown Calculator. These are two great tools that I use to easily calculate the expectancy, drawdown, and R-multiple ratios vital to a successful trading system.
Confidence is the result of hard evidence. Doing your own research, your own testing, and coming to your own conclusions helps to instill this confidence. Once you develop a strategy with a positive expectancy you begin to trade with confidence and take every setup without hesitation.
Knowing that your system yields a positive expectancy leads to consistent profits over time.
A great resource on expectancy and position sizing is Dr. Van Tharp’s book Trade Your Way to Financial Freedom. It’s one of those books chalked full of nuggets and trading wisdom.