Expectancy: What Is Expectancy in A Nutshell?

Expectancy
At the heart of all trading is the simplest of all concepts—that the bottom-line
results must show a positive mathematical expectation in order for the trading
method to be profitable. ~Chuck Branscomb
What is expectancy in a nutshell?
A trading system can be characterized as a distribution of the R-multiples it

generates. Expectancy is simply the mean or average R-multiple generated.
What does that mean?
By now you should know that in the game of trading it is much more efficient to
think of the profits and losses of your trades as a ratio of the initial risk taken (R).
But let’s just go over it again briefly:
One of the real secrets of trading success is to think in terms of risk-to-reward

ratios every time you take a trade. Ask yourself, before you take a trade, “What’s
the risk on this trade? Is the potential reward worth the potential risk?”
So how do you determine the potential risk on a trade? Well, at the time you
enter any trade, you should pre-determine some point at which you’d get out of
the trade to preserve your capital. That exit point is the risk you have in the trade
or your expected loss. For example, if you buy a $40 stock and you decide to get
out if that stock falls to $30, then your risk is $10.
The risk you have in a trade is called R. That should be easy to remember
because R is short for risk. R can represent either your risk per unit, which in the
example is $10 per share, or it can represent your total risk. If you bought 100
shares of stock with a risk of $10 per share, then you would have a total risk of
$1,000.
Remember to think in terms of risk-to-reward ratios. If you know that your total
initial risk on a position is $1,000, then you can express all of your profits and
losses as a ratio of your initial risk. For example, if you make a profit of $2,000 (2
x $1000 or $20/share), then you have a 2R profit. If you have a profit of $10,000
(10 x $1000) then you have a profit of 10R.
The same thing works on the loss side. If you have a loss of $500, then you
have a 0.5R loss. If you have a loss of $2000, then you have a 2R loss.
But wait, you say, how could you have a 2R loss if your total risk was
$1000? Well, perhaps you didn’t keep your word about taking a $1000 loss and
you didn’t exit when you should have exited. Perhaps the market gapped down
against you. Losses bigger than 1R happen all the time. Your goal as a trader
(or as an investor) is to keep your losses at 1R or less. Warren Buffet, known to
many as the world’s most successful investor, says the number one rule of
investing is to not lose money. However, contrary to popular belief, Warren Buffet
does have losses. Thus, a much better version of Buffet’s number one rule
would be to keep your losses to 1R or less.
When you have a series of profits and losses expressed as risk-reward ratios,
what you really have is what Van calls an R-multiple distribution. As a result, any
trading system can be characterized as being an R-multiple distribution. In fact,
you’ll find that thinking about trading system as R-multiple distributions really
helps you understand your system and learn what you can expect from them in
the future.
So what does all of this have to do with expectancy?
When you have an R-multiple distribution from your trading system, you need to
get the mean of that distribution. (The mean is the average value of a set of
numbers). And the mean R-multiple equals the system’s expectancy.
Expectancy gives you the average R-value that you can expect from the system
over many trades. Put another way, expectancy tells you how much you can
expect to make on the average, per dollar risked, over a number of trades.
So when you have a distribution of trades to analyze, you can look at the profit
and loss of each one of the trades that was executed in terms of R (how much
was profit and loss based on your initial risk) and determine whether the system
is a profitable system.
Let’s look at an example:
Entry Stop 1R Actual Exit Price Profit/Loss

Price

Trade One $50.00 $45.00 $5.00 $60.00 2R gain
Trade Two $22.00 $20.00 $2.00 $16.00 3R loss
Trade Three $100.00 $80.00 $20.00 $300.00 10R gain
Trade Four $79.00 $70.00 $9.00 $70.00 1R loss

Total R8R
Expectancy (Mean = 8R / 4) 2R

So this “system” has an expectancy of 2R, which means you can “expect” to
make two times what you risk over the long term using this system, based on the
data that you have available.
Please note that you can only get a good idea of your system’s expectancy when
you have a minimum of thirty trades to analyze, and the preference would be to
have 100 to 200 trades to really get a clear picture of the system’s expectancy.
So in the real world of investing or trading, expectancy tells you the net profit or
loss that you can expect over a large number of single unit trades. If the total
amount of money in the losing trades is greater than the total amount of money in
the winning trades, then you are a net loser and have a negative expectancy. If
the total amount of money in the winning trades is greater than the total amount
of money in the losing trades, then you are a net winner and have a positive
expectancy.
Example, you could have 99 losing trades, each costing you a dollar. Thus, you
would be down $99. However, if you had one winning trade of $500, then you
would have a net payoff of $401 ($500 less $99)—despite the fact that only one
of your trades was a winner and 99% of your trades were losers.
We’ll end our definition of expectancy here because it is a subject that can
become much more complex.
Van Tharp has written extensively on this topic and it is one of the core concepts
that he teaches. As you become more and more familiar with R-Multiples,
position sizing and system development, expectancy will become much easier to
understand.
To safely master the art of trading or investing, it is best to learn and understand
all of this material. Although it may seem complex at times, we encourage you to
persevere because like any worthwhile endeavor, as soon as you truly grasp it
and then work towards mastering it, you will catapult your chances of real
success in the markets.

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What is expectancy in trading?

How is expectancy calculated?

Expectancy

What is expectancy in a nutshell?

A trading system can be characterized as a distribution of the R-multiples it

What does that mean?

But let’s just go over it again briefly:

One of the real secrets of trading success is to think in terms of risk-to-reward

So what does all of this have to do with expectancy?

Let’s look at an example:

Entry Stop 1R Actual Exit Price Profit/Loss

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