Today, we will discuss mathematical expectations in trading. Mathematical expectation refers to the average outcome of a trading strategy over many trades, taking into account both profits and losses. It's a statistical concept that helps traders assess the potential profitability of their strategies.
There is a simple formula for calculating the mathematical expectation of a strategy:
Math Expectation = (Pw * Aw) - (Pl * Al)
Pw (Probability of Win): The percentage of trades that result in a profit.
Aw (Average Win): The average profit per winning trade.
Pl (Probability of Loss): The percentage of trades that result in a loss.
Al (Average Loss): The average loss per losing trade.
You can apply this formula both for an existing trading strategy and when backtesting new ones without the risk of losing real money.
To calculate the mathematical expectation of a trading strategy, you need to follow these steps:
- Define Your Trading Strategy: Clearly define your trading strategy's rules, including entry and exit criteria, position sizing, stop-loss levels, and profit targets.
- Collect Data: Gather historical data for your trading assets. This could include price data, volume data, and any other relevant information needed to backtest your strategy.
- Backtest Your Strategy: Use historical data to simulate your trading strategy. Apply your entry and exit criteria to each trade according to your established rules. Track the profits and losses for each trade.
- Assess Risk-Reward Ratio: Evaluate the risk-reward ratio of your strategy. This involves comparing the average size of your winning trades to those of your losing trades. A favorable risk-reward ratio indicates that potential profits outweigh potential losses.
- Consider Transaction Costs and Slippage: Consider transaction costs (such as commissions and fees) and slippage (the difference between the expected price of a trade and the price at which it's actually executed). These factors can affect the overall profitability of your strategy.
- Monitor Performance: Continuously monitor the performance of your trading strategy in live market conditions. Adjust your strategy based on changing market conditions and new insights from ongoing analysis.
The amount of profit a strategy should aim for depends on various factors, including risk tolerance, trading capital, and the specific goals of the trader. Some traders may aim for consistent, smaller profits with lower risk, while others may pursue larger profits with higher risk. Ultimately, traders must define their profit targets based on their circumstances and trading objectives.
In the end, the mathematical expectation should be positive, and the further the value is from zero, the more profitable and stable the strategy will be. It is also important to note that while a positive expectation is a good sign of a profitable strategy, it does not guarantee success in every trade. Traders must also consider risk management, market conditions, and other factors to effectively implement and maintain a profitable trading strategy.