Updated from its original posting on May 2013
When you are trading forex, how valuable is it for you to be right? Out of ten trades, if you were right eight times, would that make you happy? How about only half the time, is that still okay? How about twice? What’s your limit?
It might seem like an important question, but if you look at the bigger picture, it doesn’t really matter.
“Dr. Pipslow, how can you say that? Surely, you can’t make money if you aren’t right in at least most of the trades that you take!”
In forex, you must realize that making money and being always right aren’t mutually inclusive. What this basically means is that one can exist without the other.
There is such a thing called the reward-to-risk ratio. Take this hypothetical situation for example. Let’s say at the end of the year 80% of your 50 trades were losers. After making some computations, you have found out that your average loss was roughly $100. At first glance, you might seem like a terrible trader–you lost 40 of your trades, which translates to about $4000 in losses.
Upon closer inspection, however, you saw that the other ten trades had a big reward-to-risk ratio. Your average winning trade was $500. You basically end up making $5000 on your winning trades and losing only $4000 on your losing trades. At the end of the year, you are still profitable even though you were right only 20% of the time.
Now let’s take a look at an opposite scenario. What if, instead of being wrong 80% of the time, you were right 80% of the time? This happened because you would close your trades immediately after they went a few pips in your direction.
As for the losing trades, you’d just let them run because you just cannot handle the thought of losing. The 40 winning trades had an average gain of $50. Your losing trades, however, averaged $500. By the end of the year, you have won $2000 but lost $5000.
This just goes to show that you shouldn’t focus just on being correct. You have to take into consideration the expectancy of all your trades.
Expectancy is one of the most crucial aspects of any trading strategy. Unfortunately, most people tend to overlook this aspect and stick to focusing on the profits of each trade.
For those of you who are unfamiliar with this term, it’s time to get some forex education!
Expectancy is basically the amount you stand to gain (or lose) for each dollar of risk. The formula for expectancy is this:
Expectancy = (average gain X probability of gain) – (average loss X probability of loss)
Let me give you an example to clarify this.
Let’s say that Mark has a trading account with a balance of $10,000. Over the years, Mark has realized that he wins about 40% of the time, and that he makes about $250 per trade. When he loses (which happens 60% of the time), he loses an average of $100 per trade.
So what is Mark’s expectancy?
Expectancy = ($250 X .40) – ($100 x .60) = $100 – $60 = $40
This means that Mark can expect to earn $40 per trade in the long run. Notice how Mark was able to generate a positive expectancy despite losing more trades than he wins. So after 100 trades, Mark should stand to gain $4,000 ($40 x 100).
On the flip side, if Mark had a much higher probability of winning but his average gain was smaller than his average loss, he would actually see his account slowly get depleted in the long run.
Here’s an example.
Let’s say that Mark’s average gain per trade was $100 per trade and his probability of gain was 60%. His average loss is about $200 and his probability of loss is 40%.
This gives him an expectancy of ($100 x .60) – ($200 x .40) = ($60 – $80) =-$20.
This means that for every trade, Mark can expect to lose $20. It might take a really long time, but his account will eventually be emptied if he maintains this level of expectancy.
The point is, don’t be suckered into believing that traders who win 90% of all their trades end up profitable in the long run. When trading in the forex market, being right most of the time isn’t as glamorous as you would think it would be. To be profitable, all you need to have is a positive expectancy.