BarroMetrics Views: Expectancy Return
In recent years, the Expectancy Return Formula has become the flavour of the month. The formula:
(Average Dollar Win x Win Rate) – (Average Dollar Loss x Loss Rate) = Expectancy Return
- Expectancy Return: is the return we believe we’ll see per trade over a large sample size
- Average Dollar Win: is the total dollars made/the number of winning trades
- Win Rate is: the number of winning trades/total number of trades
- Average Dollar Loss: is the total dollars lost/the number of losing trades
- Loss Rate is: the number of losing trades/total number of trades
I have written about the formula in other contexts; but today I want to focus on what the Win Rate/Loss Rate tells us and what the Avg$W/Avg$L tells us.
The Win Rate/Loss Rate tells us how well we are reading the market. It’s a function of our market understanding and/or the relationship of our understanding and the state of market i.e. is our understanding in Ebb State or Flow State (see http://tradingsuccess.com/blog/ebb-flow-how-to-identify-675.html). There is no doubt that my understanding of market action is much better than it was when I started trading 30 years ago. I am able to have some chance of being correct when I assess the future path a market may take. When I started 30 years ago, I could no more do this than pigs could fly. So what does this better understanding mean?
A low Win Rate or high Loss Rate tells us either that:
- We need to improve our understanding i.e. get an education or
- We are in Ebb State and we need to take defensive action until the state passes.
What is HIGH/LOW in this context? This depends on your trading timeframe and your past results. The shorter the timeframe, the higher the Win Rate and the smaller the AVG$Win. Understanding this relationship is key to improving our Win Rate.
What about the AVG$Win/AVG$Loss? What does that tell us?
The AVG$Win/AVG$Loss tells us how well we are executing the trades. When I am trading well, I seldom get stopped out: the reason is I recognise early that my perceived low risk opportunity exists in my mind rather than in reality; and as a result, I exit my position before the stop is elected. Needless to say, when trading well, the early exit is correct…by that I mean, my stop would have been hit but for the early exit.
So are the two elements as distinct as I have made them here? If you think about it, the answer must be ‘no’; the two, WinRate and AVG$Win do merge together. That said, I do find it useful, for my journal reviews, to separate them. By approaching them in this way, I have often been able to take the action I need to improve my bottom line.