The Expected Value of the Trade
In This Week’s Issue:
- Stockscores Upcoming Events
- Stockscores’ Market Minutes Video – Know Your Edge
- Stockscores Trader Training – The Expected Value of the Trade
- Stock Features of the Week – Abnormal Breaks
Stockscores Upcoming Events
Two free webinars coming soon. Click here to register and scroll down the page to see the free events.
- How to Become a Successful Day Trader – Tuesday May 29th at 6PM PT
- How to Become a Successful Stock Investor – Thursday May 31 at 6PM PT
Stockscores Market Minutes – Know Your Edge
Beating the market requires an edge. This week, I discuss the importance of an edge in trading, my weekly market analysis and the trade of the week on SBUX. Click here to watch
To get instant updates when I upload a new video, subscribe to the Stockscores YouTube Channel
Trader Training – The Expected Value of the Trade
As a trader, how you judge success will have an effect on how you approach the market. Define success incorrectly and you may doom yourself to failure before you ever make a trade. I think unrealistic expectations are a major reason why most people cannot make it as traders. I want to help by showing you how to judge performance and what your expectations should be.
Conventional wisdom leads most to judge success using percentage gain over a period of time. This seems to make a lot of sense, but it has problems. Anyone can get lucky in the relative short term, making them think that they are smart because the market hands them some nice returns. However, the market cycles and if you fail to catch one of the strong up cycles that lets everyone be a winner, you will probably lose it all.
Risk management needs to be part of your criteria for judging success.
It is also important to recognize that the stock market is extremely hard to beat and it is nearly impossible to know what one individual stock will do. With good strategy testing, you can judge what a set of rules will achieve over a large number of trades and use that as your gauge.
Therefore, it is dangerous to judge success over a small number of trades.
A strategy's potential is measured by its expected value. A strategy that is wrong 90% of the time can still be a great money maker if it makes a lot when it is right. With the same logic, there are strategies that are almost always right but which still lose money because the gainers are outweighed by the losers.
So, do not judge success the way you judge performance on a test, it is about how much you make when you are right versus how much you lose when you are wrong.
Each trade does not have an equal weighting in the measure of overall success. In my trading, I find that I have lots of small winners and small losers that tend to balance each other out. However, it is the occasional big winners that serve as the source of most of the profits.
You have to be patient to let the big winners happen.
Let's now go through an example of how a trading strategy might work.
Suppose you have a set of rules which, after exhaustive testing, has the following characteristics:
- Right 70% of the time, wrong 30% of the time
- When it is right, the average profit is two times the average loss
- The most common profit is one times the average loss
- Once in ten trades, there is a profit that is five or more times the average loss
How would unrealistic expectations destroy the potential of this strategy?
What would happen if the trader expected to never be wrong and, as a result, hung on to his losers until they became winners? Since some trades will never be winners, this would mean he would have much larger losers than the disciplined trader who used stop loss points and planned his losses. Instead of having an average reward for risk of two to one, it might be one to two.
What would happen if the trader judged her performance one trade at a time? With each win - elation. With each loss - despair. This emotional rollercoaster would affect their ability to make the right trading decisions and eventually the trading rules would be broken. The trader would fall apart.
What would happen to the trader who did not understand the expected value of their trading strategy? They would likely fail to limit downside and maximize upside. They would think it was good to make a certain amount of money on a trade rather than judge their success by how much reward they earned for the risk that they took. In time, they would be broke.
Finally, what would happen to the trader who failed to let the big trades happen? Since the majority of their profits come from a minority of their trades, the strategy that they tested and found to be profitable would fail to be so in real trading. The emotional desire to lock in fast profits rather than let the winners run would turn them in to traders with a high success rate but not a lot of profits.
Change how you judge success so that you can approach the market with the mindset of the winning trader. This may contribute more to your success than your ability to pick the right stocks.