In life we generally want to be right. This is why you may hear traders framing their trading success by saying they won nine out of the last 10 trades, or that they have a 90% success rate. However, this is something that you need to be weary of, having lots of winning trades does not necessarily mean that you will be a profitable trader in the long run.
Here, Simon Garner, Trading Floor Manager at Learn to Trade, lists five steps to understanding how important it is to be right when trading through your trade expectancy in order to help set yourself up for success.
- Quality over quantity: understanding reward-to-risk ratios
As traders, the risk/reward ratio is something that we need to pay close attention to. It essentially refers to how much exposure you have in the market compared to what you stand to gain. As traders we will have particular criteria that must be met in order to take a position, which will be set out according to our trading plan. Whilst this means there will only be a limited number or opportunities each month, it means each trade is carefully thought through.
- Mental expectations: finding your winning percentage
This is something that many new traders have an unrealistic expectation about. Many expect a 90-100 per cent win ratio and that they will identify trades that are a ‘sure thing’. In reality this is not the case. Many profitable traders will in fact have win ratios of 60-70%, which is why having the ability to find opportunities that provide the best risk / reward ratio is so important.
- Knowing your real ratio
While being right more often than not certainly helps, to truly determine success you need to consider whether you’re making any net long-term profit. This can be shown through your average reward-to-risk ratio.
To illustrate this, imagine two traders: Sarah and Mike. Both have placed 100 trades and started with the same amount of money in their trading accounts. Mike has won 75 trades and lost 25, and Sarah 30 and 70 respectively. When Mike is right he makes a profit of £100 per trade on average, but when he’s wrong he makes an average loss of £300. This means that Mike’s reward-to-risk ratio is 1:3. Comparatively, when Sarah is right she makes £300 on average per trade and when she’s wrong she loses on average £100. This means Sarah’s reward-to-risk is 3:1.
- Finding your trade expectancy
To really understand how strategies stack up against each other, we need to take into consideration the two things: firstly, how frequently we have winning trades, and secondly, how much is gained or lost with each trade.
The solution is called trading expectancy, and it is calculated by combining your risk / reward ratio and your winning percentage. Trade expectancy essentially tells us how much we stand to gain or lose for every pound risked. It is expressed in the following way:
Expectancy = (average gain x probability of gain) – (average loss x probability of loss). We can make this a bit clearer using Mike and Sarah’s results here:
Mike’s expectancy per trade = (£100 win x 0.75) – (£300 loss x 0.25) = £0
Sarah’s expectancy per trade = (£300 win x 0.3) – (£100 x 0.70 loss) = £20
What this tells us is that over the long run Mike is breaking even with each trade despite winning 75% of the time. For Mike’s strategy to become profitable he either needs to win more often and/or reduce his risk per trade. Sarah’s expectancy tells us that she is making an average £20 per trade in the long run, even though she is winning just 30% of her trades. Her reward-to-risk strategy means that she can be wrong much more frequently than Mike, but still make a profit overall.
- Refine & repeat
Your trade expectancy can improve or worsen depending on trading conditions and whether you stick to your trading plan, nevertheless, expectancy is a good benchmark. You could also think of expectancy as how much you can theoretically expect to get paid for each trade you take over time. As such it is important to constantly track as you mature as a trader. Patience, consistency and education are the most important factors when it comes to trading and compounding interest.
As we all know, it’s impossible to always be right when trading forex. However, figuring out your expectancy helps shift focus away from being right per trade to instead how right you are overall.
What if The Apprentice (UK) was actually a credit based show rather than a strategy play? Below, Cato Syverson, CEO of Creditsafe, discusses for Finance Monthly the ‘real winner of the show’, if the win depended solely on the contestants’ past dues, credit history and debt.
This year’s series of the popular television show, The Apprentice is now in full swing. The reality TV show - now in its thirteenth series – sees 18 hopeful businessmen and women compete to become Lord Alan Sugar’s latest business partner, with the eventual winner scooping a £250,000 investment into their proposed business venture. But how does Lord Sugar whittle the 18 potential candidates down to one? What is he looking for in a business partner? By the looks of the latest series, it’s not their business or credit history.
Using Creditsafe data, we have analysed who the real winner of the Apprentice 2017 should be and who the riskiest investment would be for Lord Sugar, based purely on the contestants’ financial and business history, past success and acumen. We devised a simple scoring model to rank the candidates, considering factors such as the profitability of current businesses they own, credit ratings and whether they’ve received any County Court Judgments (CCJs).
The results indicate that interestingly, week three casualty Elliot Van Emden was the safest bet for Lord Sugar and should have been the real winner of this year’s series. With a credit rating of 95, a net worth of £27,006 and no CCJs to his name, Elliot was a strong contender and the least risky candidate in this year’s competition.
Most surprisingly, Elizabeth McKenna, one of this year’s most talked about and controversial candidates, is now the least risky candidate for Lord Sugar to enter into business with. Elizabeth has a net worth of £36,940, no CCJs and five current business appointments making her a solid choice, even though the florist has irritated a number of candidates on the show. Luckily, this week, she managed to dodge being firing by Lord Sugar when she was brought back into the boardroom as sub-team leader. At the other end of the spectrum, Bushra Shaikh has two dissolved companies under her belt, a very low credit score of 49 and one CCJ to her name, making her the least advisable selection for Lord Sugar.
While there isn’t a strict set of rules about choosing a business partner, there are warning signs to be aware of when faced with this decision: For example, if a director has any previous failures buried in their business history. Our data shows that if a director has been involved in a company that has failed in the last three years, they are nine times more likely to fail again compared to a director who has never been involved with a business collapse.
In addition, it is wise to check whether candidates have links to any businesses with low credit scores. Many businesses are owned by or have links with other companies, and how they’re performing financially can have a knock-on effect. This means it’s sensible to look at all linked companies credit reports to check you won’t be impacted by a low credit score or poor payment history of another business in the future.
We have a few more weeks to wait and see who Lord Sugar chooses as his next business partner, but it will be interesting to see if he takes a risk or makes a safe bet. Who you enter business with can have a significant impact on both your financial performance and reputation, and therefore doing your homework on potential candidates is critical for success.
