Educational Series - Part 2

22 Jan 2017

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Continued from Educational Series - Part 1 (link below) ;

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3. Expectancy :


So, now we have got our risk reward ratio and winrate.
We move on to calculate the expectancy of our trading strategy.

The formula is,
Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

So, in our scenario,
where,

Risk Reward Ratio = 2:1
Winrate = 60%

we get,

Probability of win = 60 % = 0.6
Average win = Reward = 3
Probability of loss = 40 % = 0.4
Average loss = Risk = 1

Putting these values in the formula, we get ;

Expectancy = ( 0.6 * 3 ) - ( 0.4 * 1 )
= 1.8 - 0.4
= 1.4

Here, we get an expectancy of 1.4 ,
that is
1.4 is the average rupees you can expect to win per rupee at risk.

{Example : you do 10 trades with 3:1 Risk Reward Ratio ;
you win 60 % - earn 6 trades * 3 Rupees (18)
you lose 40 % - lose 4 trades * 1 Rupee (4)

you end up earning 14 Rupees even when you were right just 6 out of 10 times }

This is a positive expectancy model, which we seek, to ensure that we will earn money in the long run. Professional traders aren't worried if their trade hits stop loss, because of this reason, that they know they will earn money ultimately.


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NOTE :

So, after learning all these concepts,
what I want you to do is,

from now on,

pull out your charts and journal,
see what works and what doesn't,
set a specific strategy,

determine the Risk Reward Ratio suitable to it,
paper trade / real trade / past data - have a look and find out the winrate

Calculate expectancy.

What answers do you get ?
Is it positive or negative ?

How much can you expect to earn in the long run?

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Ok, so that was the first post, the essential basics of trading, and utmost requirement of a trading plan .

I would like to hear from you all 3 things,

1. Whether you were able to understand and found it helpful ?
2. Whether you want more posts like these ? If yes, on what topics?
3. What does your expectancy come out to be ?