An understanding of Expectancy is at the heart of successful trading. Trading is a probabilistic game, and outcomes are expressed in terms of probabilities, not certainties.
Many amateur traders focus on one metric: the win/loss ratio or the Win Percentage. People like winning, and so having a high Win % feels good. It syncs nicely with other walks of life, such as sport: if your team wins more games than it loses the team tends to do well.
Unfortunately, the sporting analogy quickly breaks down. In sports, it does not often matter how much you win by: winning by a field goal or eight touchdowns still puts a “W” in the column. In trading, it very much matters how much you win by.
Imagine a trading system that produces ten trades. You win $100 on eight trades. But you lose $500 on two trades. Your Win Percentage is 80%, but you have lost $200 across all ten trades.
The Average Win/Average Loss ratio is just as important as the Win/Loss ratio.
Expectancy = (Win % x Average Win) – (Loss % x Average Loss)
or, in our example:
Expectancy = (80% x $100) – (20% x $500)
= $80 – $100
This trading system has negative expectancy. That does not mean it will always lose money: trading is a probabilistic game, and there is a reasonable chance of a string of winning trades. But in the long run, the system will lose money.
With a positive expectancy, the longer you play the more you win. With a negative expectancy, the longer you play the more you lose.
Which brings us to Vegas. Last year, nearly 39m people visited Las Vegas, of which 77% gambled. Almost everything in Vegas is a negative expectancy game for the public and a positive expectancy game for the casinos. The casino might not win each play, but the odds are in their favor. That is why casinos try so hard to keep you playing as long as possible. They even like it when you win, since that encourages you to play longer. They know they will win in long run.
In trading, it is important to develop a mentality or technique that puts you in the position of the casino, not the public. You do that by identifying and creating situations that have positive expectancy. You will not win every time. You may even lose the majority of the time: you can lose on 60% of your trades and still make money overall if your average winning trade is at least 50% larger than your average losing trade.
It appears that most people do not think about expectancy very much: the 39m people who gambled in Vegas last year to start with. Traditional fundamental analysis primarily deals projections and forecasts and very little with Expectancy. As Warren Buffett realized on his honeymoon, getting rich should not be a problem when plenty of rich, well-dressed people participate in games where the odds are against them.