This is what really drives profitability in your trading

Foreign.

If you're an analytical person and you're new to trading, you want to figure out how making money in the markets really works. This video is for you. One of the biggest misconceptions about profitable trading is that you have to be right. You have to be right a lot in order to make money. And you know, this is perpetuated by the school system. And you know when you do exams at school and university, you have to get high grades, high percentage of the questions right in order to be successful. And we carry this into our trading and unfortunately it's dead wrong and very misleading. So in trading there's a thing called expectancy. And if you're new to trading and you're an analytical person, you're just going to love this calculation. Super simple, but it just explains how the profit really works. Expectancy is the calculation. It tells you how much money you expect to make when you take the same trade or the same type of trade over and over and over again. I've got a real simple expectancy calculator here and I want to share it with you now. So I got a bunch of scenarios, but I'm going to zoom in and just talk about the calculation to begin with. In its simplest form, the expected profit per trade is the average profit of your winning trades times the percent winners, minus the average profit of your losing trades times the percentage of losers. You can see here that if we win $100 on a trade and we're right 50% of the time and we lose $100 on a losing trade and we're wrong 50% of the time, then we're at break even. So so far so good. So there's a whole bunch of different scenarios that can play out here because there's many different ways we can trade. We can have systems that are very high win rate systems and we get a lot of winners, but the losers tend to be pretty big. We can have systems that are low win rate but tend to have small losing trades and big winning trades. So let's have a look at some calculations for each of these different scenarios. And then I'll show you the calculations for a couple of systems, one of which I'm going to be teaching at Market Mastery boot camp coming up really soon. So here's the calculations again. Let's look at scenario one. This is a scenario where we're making a small amount of profit per trade, $30 on each trade. We're right 80% of the time, but the average loss is big. It's $120 on the trade. And we're only wrong 20% of the time. And this is a break even scenario. Now you might be thinking, okay, well, I can make $30 per trade. There's no way I would lose $120 per trade. But in order to be right 80% of the time, we actually need to have very wide exits. We need to give our trades a lot of room to move, because this is a typical sort of mean reversion scenario. And in mean reversion, what happens is the markets are falling and we're buying in anticipation of a bounce. And as the market falls, we buy because we think the down move is overstretched and we're looking for a small bounce to profit. But the trouble is, when we enter these trades, the market can keep moving against us for some time. And if it doesn't turn around and bounce, then, because we got to give it a lot of room to move to allow the bounce to happen, we can end up with high average losses on each trade, on the losing trades. So with.

Mean reversion trading, the key to success is to make sure that the losing trades are not too big. You know, we've got to keep them under $120 in this scenario to break even. And the winning trades, we're going to make sure they're large enough. And we have a balance here between the size of the wins and losses and the percentage of wins and the percentage of losses. Typically you'll find when you try and target very, very high win rates, 85, 90, 95% or more, the equity curve ends up looking really nice and beautiful and smooth. But the problem is you get lots and lots and lots of winners. But every now and then, a really large loss can come along and wipe out most of your profits. So going for something like 60, 70, 75, even, 80% winners in a mean reversion system gives you a much bigger margin for error because you can keep your losses smaller than you can if you're going for a very, very high win rate system. Because in order to get 95% of winners in a trading system, you have to give the trades a lot of room to move. And that leaves you open to some very large losses. Have a look at another scenario here. This is a more of a trend. Well, this is a sort of break even scenario. Again, we got $30 win on each trade, 50% winners, $30 lost, 50% losers. So this is where if you're right about 50% of the time, so if you're right about 50% of the time, your wins and your losses only have to be the same size to break even. But it's actually pretty easy to allow your wins to run just a little bit and end up with a positive expectancy. The way you let your wins run a little bit is to have a trailing stop which allows the winners to keep moving in your favor, rather than a profit target which caps your loss at a certain capsule win at a certain size.

You could also preset your stop loss width and your profit target width so that you get a ratio of wins to losses that gives you a positive expectancy as well. I personally prefer a trend following approach which allows the winners to just go as big, go as long and as far as they can, allowing the wins to get really big. And that's what scenario three here is like. This is a typical trend following scenario. Let's say you have an average win of $30, but only 30% are winners. And then an average loss of 13. You've capped your loss at a pretty small value by having a tight stop loss and you're wrong 70% of the time. This is also a break even scenario. So. But you can make this more profitable by allowing your wins to run and get bigger. This is all very theoretical. That's great, Adrian. Why are you showing me all of these things? Show me something real. So let me show you this next one which is a.

Let me just fix that. There we go. This scenario four here is a real trading system. It's a very ultra simple trend following system that I've got. You can see the average win is $43, 46% of trades are winners. The average loss $13. 54% of trades are losers for an expectancy of 13. And when you let that play out, you get a nice beautiful equity curve like this. So that makes really good. Had made really good returns over the last 20, 30 years just by following long term trends. And then finally I've got one more scenario here, which is another mean reversion scenario. And this is the strategy that I'm going to be teaching at Market Mastery Bootcamp coming up really, really soon. So here we go. This scenario has a $47 average win, but it's right 77% of the time. The average loss is $55. So the average loss is a little bigger than the average win and it's wrong. Or it has a losing trade 23% of the time for an expectancy of $24 per trade. And when you let this play out time and time again over many Trades, this is what the equity curve looks like. So if you want to make money in the markets, the key thing you need to understand is that your profit doesn't come from being right. It comes from being right on enough trades so that your average win, average winners overcome your average losers. So we need to think about the expectancy equation and think about that analytically as we're designing our trading strategy. And if you try and take profits too quickly, you've got a very tight profit target, then it's much harder to have a positive expectancy. But if you let your profits run with a trailing stop, like we do in trend following, then it's much easier to have a positive expectancy. You can also have a mean reversion system that's got a great positive expectancy like the one I just showed you, which gives you profit by having a very accurate entry trigger and a quick exit that allows you to have a substantial gain without giving too much up on the downside. So there's many different ways to be profitable. You've just got to think about the expectancy equation. Vary the size of your wins and size of your losses and the percentage of winners. And the way we do that is by adjusting the different components of our trading system to increase the percentage of winners. You would need a more accurate entry trigger. You also need a wider stop loss, and you need a tighter exit on the winning trades to increase the size of the winners. You need a looser entry, sorry, a looser exit. And you need to let the profits run a little bit more. So depending on what components of the trading system you flex, you can adjust the expectancy equation. So trading is about more than just being right. It's about understanding analytically how does the. How does the math lead to profit? And the expectancy equation is the foundational principle behind all of that. So if you want to learn more about how to become a profitable trader and how to use analysis like this to make your trading decisions, design trading strategies that work and then back test them over 20, 30 years of market history. Click the link in the description below, register for Market Mastery bootcamp. And over two days, 90 minutes each day, we're going to run a live workshop and and I'll take you on the whole journey from launch to mastery and show you everything you need to understand and master in order to become a consistent and profitable trader. My name's Adrian Reed. This is enlightened stock trading. And I hope to see you at Market Mastery.