Thread by @tradersushma

Is Positive Expectancy of a System sufficient data to determine whether the system is successful or not ?

What else to check besides the expectancy of a system ???

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WHAT IS EXPECTANCY?

Expectancy represents the average amount of money we make for every Rupee we risk.

It is an average gain in terms of the initial risk taken i.e. R.

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In simple terms,

Expectancy is the average amount one can expect to win (or loose) per trade with their system, when a large number of trades are taken.

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EXPECTANCY FORMULA ~

Expectancy = (% winners x R multiple of avg win) – (% losers x R multiple of avg loss)

Eg.

If there is 50% chance of winning with each avg win as 2.4 times average R,
Expectancy = (50% x 2.4R) – (50% x 1R) = 0.7 R

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The above formula is used when we don’t have data for each trade & have overall results or predicted values.

But if we have a history of each trade taken, we can calculate expectancy by adding each trade’s R multiple & divide by total no of trades.

Eg.

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What is R multiple?

To understand expectancy, we need to think every trade in terms of initial risk taken i.e. R.

Eg.
A system goes long @ Rs 51
SL @ 48
Risk taken for this trade = (51-48) = Rs 3
Suppose Rs 9 is the profit
R multiple = 9/3 i.e. 3R

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Expectancy can be both – POSITIVE & NEGATIVE.

If it’s negative, the strategy is a loser. If it’s positive, the strategy is a winner.

Eg 0.5 Expectancy of a system means for every 1 Re risked we gain an avg of 50 paise.

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Is positive expectancy sufficient enough to know that it is a winner/profitable system?

No!

After knowing the expectancy of a system, we need to know certain other parameters of the strategy.

One such parameter is FREQUENCY of trades in that system.

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Eg.

A system of expectancy 5 with frequency of 2 trades a month will give Rs 1 lac for every Rs 10K risked (5 x 2 x 10K) while a system of expectancy 0.8 with frequency of 20 trades a month will give Rs 1.6 lacs for every Rs 10K risked (0.8 x 20 x 10K).

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Only after knowing the frequency of trades in the particular strategy one can calculate the profitability of a system.

The formula is ~

PROFIT = EXPECTANCY X FREQUENCY X RPT

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Despite high expectancy of a system, low frequency of trades makes it less profitable than the low expectancy high frequency trading system. This comparison highlights the number of opportunities a system provides per time period.

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Off course, we will have to consider the higher transaction cost involved in higher frequency of trades. So, make sure to include all these extra costs in these calculations as well.

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Hence +ve expectancy is not sufficient for a system to be profitable. There has to be a critical expectancy for a system to survive. Caln for critical expectancy includes all extra costs involved in a strategy- transaction costs, impact cost, taxes etc.

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Read the thread below to find out all about the charges involved in equity trading.

https://twitter.com/tradersushma/status/1430531800489611265?s=20

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SUMMARY

🔹Expectancy alone is not sufficient to calculate the profitability of a system.

🔹It has to be combined with frequency of trades to calculate the profitability of a system.

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🔹While calculating expectancy, make sure to include all the extra costs involved in that transaction.

🔹This principle applies for all the financial instruments be it stocks, commodities, real estate etc.

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🔹This approach is helpful in comparison of various strategies & choosing the best one.

🔹PROFITABILITY should be the goal. Always choose higher profitability over higher probability.

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That’s all for this thread.

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I keep sharing useful threads on #trading & #investing
Stay tuned for the forthcoming ones!

Thank you!

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