Expectancy Ratio Explained

What is your expectation for Profit on any trade relative to the Risk you are taking?

This is known as the “Expectancy Ratio” for any given trade and ties in the two metrics of Batting Average and Risk/Reward Ratio.

We have discussed previously that a high Batting Average is no good if the size of your winners is too small. 
Similarly having a very high Risk/Reward Ratio may be misleading if the frequency of those winners is too small.

So by calculating your Expectancy Ratio you are combining your Batting Average and Risk/Reward metrics into one number. This is expressed as a % or multiple of your average loss to give you an idea of your expected profitability relative to the risk you are taking.

For the more mathematically minded this is calculated as
(Batting AverageAveWinPnL + (1-Batting Average)AveLosePnL) / AveLosePnL

In Numbers… 
Let’s assume as an example your average winning trade nets you +$500 and your average losing trade loses you -$200. This means the Risk/Reward Ratio for your trading system is 2:5. 
(Note: This is often quoted as 5:2, putting the value for Reward first.)

Now assume in a system of 100 trades you have 40 winners and 60 losers. This means the BattingAverage for your system is 40%.

 

Using the formula above we get
(0.4x500 + 0.6x-200) / 200

(200 -120) /  200

= 0.4