What is expectancy in a nutshell? Lesson 1
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? Stick with us here a second while we review R and R Multiple in just a few sentences: 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 $2,000, then you have a 2R loss.
“But wait, you say, “how could you have a 2R loss if your total risk was $1,000?” 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 systems as R-multiple distributions really helps you understand your system and learn what you can expect from them in the future.