If you are looking to increase the amount of profit you are making from your trades and are failing to understand why you may not be, knowing the expectancy ratio of a trade before you make it can help.
The expectancy ratio is a calculation that helps you to determine the expected profit or loss of a single trade after taking into consideration all of your past trades and their wins and losses. With this, you are always looking for a positive expectancy to show you that the trade is profitable.
To better choose trades to improve your profits, knowing the expectancy ratio of a trade is the closest thing you can get to see into the future. To find out more about what expectancy is and how you can calculate the expectancy ratio of a single trade, keep on reading and let us dive right in.
What Is Expectancy?
If you plan to actually turn a profit off of trading, whether through stocks, equity, futures, or cryptocurrency, you need to have a strategy and a general understanding of what you can expect in the future. The expectancy refers to the profits your trade is expected to produce.
If you want to learn more about gaining an edge in trading with expectancy, you can watch the video below:
If you do not have a strategy, you may find you are trading randomly. Without understanding expectancy, it puts you in a high-risk position and you are more likely to lose money.
Expectancy helps you look at how your trades have won and lost in the past, along with the trades potential gains or losses to see how it will produce a profit for you in the future. By taking into consideration the reward-to-risk ratio and combining it with your win and loss ratios, you can find this out.
With the two ratios together, it will then become one of you and many investors’ best tools in predicting the future outcome of a trade.
The reward-to-risk ratio helps investors’ understand how much money they can earn for each dollar they risk on a trade.
This ratio is often used to help decide which trades should be taken, so it is known how much will be lost if the trade goes in an unexpected direction.
If you are willing to risk $20 for the potential of earning back $30, it means you are willing to risk losing $20 for the potential of earning an additional $10.
If you lose, you will lose $20 and if you win, you will win $10.
Your reward-to-risk ratio would be 20:10/2:1 or 0.5, essentially this ratio is found by dividing how much you could win by how much you could lose.
This can also be looked at as a risk/reward ratio, which would be 1:2 in the case above. This would suggest that the investor is willing to risk $2 for a potential reward of $1.
The Win/Loss Ratio
The win/loss ratio does not take into account any money, but simply how often an investor wins a trade versus loses a trade. This ratio may also be referred to as the success ratio.
It is easily calculated by dividing the number of trades lost from the number of trades won and is used to analyze how successful a trader is.
If there were 20 trades made within a day, where 8 of them were wins and 12 of them were losses the ratio would be:
8 / 12 = 0.67
In percentage form, this would translate to 67% by multiplying the decimal by 100. A win/loss ratio of 0.67 or 67% means that your trades are losing 67% of the time.
The Win Ratio
The win ratio looks at the winning side of the win/loss ratio. Dividing the total number of wins by the number of total trades.
Using the same numbers from the example above the ratio would be:
8 / 20 = 0.4 or 40%
With a win ratio of 0.4 or 40%, it means that 40% of the time, your trades are winning.
Note: In some cases, your win ratio may be lower than your loss ratio, this does not mean it is not profitable; it just makes it more important to look at your reward-to-risk ratio.
The Loss Ratio
The loss ratio looks at the losing side of the win/loss ratio. Dividing the total number of losses by the number of total trades.
12 / 20 = 0.6 or 60%
With a loss ratio of 0.6 or 60%, it means that 60% of the time, your trades are losing.
You can also calculate the loss ratio by subtracting the win ratio from 1 if it is in decimal form, or from 100% if it is in percentage form.
Win Ratio = 40%
Loss Ratio = 100% - 40% = 60%
Calculating the Expectancy Ratio
To calculate the expectancy ratio, you will need to first calculate the reward-to-risk ratio, the win ratio, and the loss ratio, as demonstrated previously. Once you have done that, it is best to keep these in the decimal form if you plan to use a calculator.
The expectancy ratio is then calculated by taking the reward to risk ratio and multiplying it by the win ratio, and then further subtracting it from the loss ratio.
The formula is as follows:
(Reward-to-Risk Ratio X Win Ratio) - (Loss Ratio) = Expectancy Ratio
Win Ratio: 0.6 or 60%
Loss Ratio: 0.4 or 40%
(1 X 0.6) - (0.4) = 0.2
This means that this trade will return 0.2 times the size of your losing trades. You now know you have a positive expectancy, meaning it will turn a profit and a number you can use to compare it to other trade options.
Win Ratio: 0.6 or 60%
Loss Ratio: 0.4 or 40%
(0.5 X 0.6) - (0.4) = -0.1
Even though this trade had a higher win ratio than the loss ratio, the expectancy ratio is still negative. This trade will return -0.1 times the size of your losing trades. With the expectancy being negative, it suggests that this trade will lose you money in the future and is most likely one you should not make.
Expectancy Ratio Limitations
Since this calculation is completed using past data, it is important to remember that although any expectancy greater than 0 is profitable in the past, you need to find profitable ones in the future.
Since we can only predict what will happen, it is not likely that your predictions will perfectly line up with what actually happens and you need to take this information with a grain of salt.
To double-check and compare trading strategies, the expectancy ratio is a great calculation to use. If you find that your expectancy is positive, you have the potential to make money. If it is negative, then you will know that it is not a good trade to make.
While this ratio proves as a great resource for being more strategic when planning your trades, you must also consider factors such as trading costs and position sizing. By taking into consideration all of these things, you can set yourself up in a good position for making a good profit trading.