The Expectancy Return formula identifies the key area on which we need to focus.
Most newbies focus on the win rate. But the win and loss rate are less under our control than the Avg$win and Avg$Loss. This post will explore the reasons for this.
No matter how good a trader we may be, we will experience drawdown periods – where everything we do is wrong. On the flip side, we have long-term losing traders with periods where all they do turns to gold. I believe the reason for the phenomena lies in the nature of free markets. I liken the market to waves within a limitless circle; and I liken our market knowledge and trading plans as a rectangle within the circle. As long as the waves wash into our rectangle, we enjoy success; the more our rectangle is filled, the more success we enjoy.
But when the waves recede from our rectangle, we experience drawdown periods. In this metaphor, we have little control over our win/loss rate; it depends entirely on whether or not the tide is in our rectangle. Sure we can increase the size of rectangle (i.e. increase our self and market knowledge); but since the circle is limitless, we can never know enough to prevent the drawdown periods.
On the other hand, the Avg$Win and Avg$Loss is totally within our control because they are dependent on our entry and exit. By focusing on expanding the difference between our Avg$Win and Avg$Loss, we create our profitability.
By the way, it’s easier to decrease the loss than to increase the profit. When I take a trade I ask a series of questions whose answers prepare an exit before my stop is hit. One of the questions I ask myself is: “What does the trade have to look like for me to remain in the trade?”. Another question is: “What does the trade have to look like for me to exit?”.
The attached JPG of my personal account shows the difference between a good trading month and a poor one. October was a poor month: my total Win Rate and Loss Rate were almost equal (+17 to -16); but the $Loss was 1.3:1 to 1.0 $Win; and as a result, I lost (3%) for the month. Now have a look at Feb 2006.
In Feb I made only $5000.00 more than October, but my losses were ($38,000) compared to October’s ($114,000.00). As a result, I made a whopping +6.9% ROI!
My results for 2006 to 2007 show we’ll make money if we focus on our entries and exits and thus increase the difference between our profits and losses. The alternative is to focus on improving our Win Rate and that is much harder to achieve.