Wednesday, April 24, 2013

Expectancy and a big winner

Although most inexperienced traders try to attain success by achieving a high win percentage, this is more often than not a way to the poorhouse. This is because, in order to get that high win percentage, they bank small profits, which are only obtained by having a wide stop in place. You quite often see in this in the myriad of automated forex trading systems touted around the internet - if you look in detail at the performance, they may well achieve a win rate in excess of 90%, but the wins will only be for a few pips, whereas the those same trades at one point may have been showing a loss of 100 pips, if not more.
The problem occurs when those trades starts going further and further against the trader, and don't come back. Or alternatively, you get a small run of 2 or 3 consecutive trades that go against you. This is when the trading account gets blown up. I talk about expectancy in my e-book, and how such a system will have a negative expectancy. The law of averages will catch up with those traders who use such a system.

Trend followers approach the markets from the opposite point of view. They accept that 50% if not more of their trades will incur losses. However they will use strict risk control and ensure that those losses are kept to an absolute minimum. With the winning trades, they will not limit the profits they make.

In my own trading, and of those trades called in the protected twitter feed, the average winner is almost three times bigger than the average loser. Also, my win rate is slightly above 50%, so I have the best of both worlds. This creates the positive expectancy in the system.

Of course, you never know which trade will create a big winner. There's no such thing as a 'can't lose' trade, which is why you apply proper risk control and position sizing on each position. Below is a chart of US stock Supervalu, in which I and some of the traders in the mentoring programme have been holding a position for a while now. As of tonight's close, I am holding an 8R profit in my position. I have placed no restriction of how big the profit will be. Who knows if it will go higher from here, or will retrace and stop me out? But by letting the trend run, I've given myself the best chance to make a big profit, which will cover a lot of small losses on other trades and leave some gains left over, helping to create the positive expectancy.

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