Expectancy in Options Trading
Expectancy is a concept that traders use to evaluate a trading strategy based on past data, according to financial website Learning Markets. The concept helps traders understand how winning trades, losing trades, gains and losses relate to each other over the long run.
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Win-Loss Ratio
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The first step in calculating expectancy is to calculate the win-loss ratio. In order to get the win ratio, add the number of profitable trades from the period of time in the past you are using to test the strategy and divide the number of profitable trades by the number of total trades. You can multiply the result by 100 in order to get a winning percentage. Subtract the win ratio from 100 in order to get the loss ratio.
Reward-to-Risk Ratio
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The reward-to-risk ratio is the average size of the winning trade divided by the average size of the losing trade.
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Expectancy Ratio
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The expectancy ratio is the reward to risk ratio times the win ratio minus the loss ratio. For example, suppose you have a system that has given 20 percent profitable trades in the past and has produced average winners six times larger than the average losers. The expectancy for this trading system would be 6 x 20 = 120 -- 80 = 40. This tells you that the system has been profitable in the past and that the average profit was 40 percent greater than the average losing trade. You can compare the expectancy ratios of different trading systems in order to determine which have been the most profitable in the past.
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