Starting with the basics
“Trading with Expectation.” What a strange statement? Do we not always trade with expectations? Of course, but the word I used is expectation, not expectations. There is a difference; and it is not just the “s” at the end of the word.
Every trader has expectations, usually of gain, when they enter a trade, However, expectation is a specific statistical concept that we use to qualify trades before we enter them. Expectation is also often called Expectancy by traders. Mathematicians more often talk of Expected Value.
By the end of this series of posts, readers will be able to calculate the Expected Value of any trading method, and use that, among other criteria to determine if a trade should be taken or not.
So what then is Expectation/Expected Value?
Wikipedia has a nice, dense tome about it, but we are traders, not mathematicians, so we shall take a simpler tack.
A traders net Expectation is a factor that depends on the likelihood of the market getting to the trade targets first, instead of the trade stops, and the size of the returns when targets are hit, ameliorated by the size of the stops and how likely said stops are to be hit.
So how do we measure Expectation/Expected Value?
First we have to measure the likelihood of our targets/stops being hit, and then we have to factor in what we make or lose in each event. In this post, we shall show how to determine the likelihood of our exits being hit.
To simplify things initially, we shall look at a somewhat simplistic scenario, so that we can clarify the concepts, then we shall discuss how the market actually relates to these concepts, and their expansions.
We shall first apply this simple measurement in a manner where all trades must terminate at either the stop or the target. In the real market, of course there will be instances where the market closes with neither exit being hit, especially if we are talking about day-trading. What we are discussing is still applicable to all trading, though.
- First we shall assume that we have what traders call a setup: a particular set of rules that must be satisfied before a trade entry will be made. It really does not matter what the setup is. We determine the expectation in the same manner, regardless.
- We shall then look at a chart and mark the last 100 times that the setup occurred. Why 100? It makes the explanation easier. We can use any large enough number of trades, so we shall just use 100 for this explanation.
- For each of those instances, we apply our stop and target and look to see if which of them is hit first. We count and record those instances in each case.
- So now we have a number of times out of 100 that our stop was hit first and another number that shows how many times that our target was hit first.
So far, all we have done is simply to make counts and keep records. With this simple count, we are now in a position to determine the likelihood of our exit (stop or target) being hit.
In the next post in this series, we shall examine how to use the counts that we just made, and what the counts mean for our trade setup.
In the meantime, if you found this useful, please leave a comment.