So what does all of this have to do with expectancy? Lesson 2
When you have an R-multiple distribution from your trading system, you need to get the mean of that distribution. (The mean is the average value of a set of numbers). And the mean R-multiple equals the system’s expectancy.
Expectancy gives you the average R-value that you can expect from the system over many trades. Put another way, expectancy tells you how much you can expect to make on the average, per dollar risked, over a number of trades.
So when you have a distribution of trades to analyze, you can look at the profit and loss of each one of the trades that was executed in terms of R (how much was profit and loss based on your initial risk) and determine whether the system is a profitable system.
Let’s look at an example:
So this “system” has an expectancy of 2R, which means you can “expect” to make two times what you risk over the long term using this system based on the data you have available.
Please note that you can only get a good idea of your system’s expectancy when you have a minimum of 30 trades to analyze, and the preference would be to have 100 to 200 trades to really get a clear picture of the system’s expectancy.
So in the real world of investing or trading, expectancy tells you the net profit or loss that you can expect over a large number of single unit trades. If the total amount of money in the losing trades is greater than the total amount of money in the winning trades, then you are a net loser and have a negative expectancy. If the total amount of money in the winning trades is greater than the total amount of money in the losing trades, then you are a net winner and have a positive expectancy.
Example, you could have 99 losing trades, each costing you a dollar. Thus, you would be down $99. However, if you had one winning trade of $500, then you would have a net payoff of $401 ($500 less $99)—despite the fact that only one of your trades was a winner and 99% of your trades were losers.
We’ll end our definition of expectancy here because it is a subject that can become much more complex. You need to have at least this basic understanding as we proceed into the next lesson on system development.
Van Tharp has written extensively on this topic and it is one of the core concepts that he teaches. As you become more and more familiar with R-Multiples, position sizing, and system development, expectancy will become much easier to understand.
To safely master the art of trading or investing, it is best to learn and understand all of this material. Although it may seem complex at times, we encourage you to persevere because like any worthwhile endeavor, as soon as you truly grasp it and then work towards mastering it, you will catapult your chances of real success in the markets.