I’ve read a lot of trading books over the years. But none of them talk about the most important concept in trading. In fact, I’m honestly shocked that I didn’t discover this critical concept sooner. So what’s the most important idea in trading?
Simply: The most important trading concept is positive expectancy.
But what does this mean?
Well, I’ve written before about the mathematics of positive expectancy. But it’s such a vital idea that I want to touch on it again. Because the truth is, without positive expectancy, you will never consistently make money over the long term.
And as far as I know, consistent profits are the goal of pretty much every aspiring trader, active investor and money manager. After all, if you aren’t consistently making money, then what’s the point?
Positive Expectancy Explained:
Although most trading and investing books don’t talk about positive expectancy, the definition is actually quite simple. It all boils down to (1) how much you win when you win and how much you lose when you lose; as well as (2) the percentage of winning trades and the percentage of losing trades. Make sense? Specifically…
Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)
If your expectancy works out to be a negative number, well, you’re never going to make it. Consistent profits become a mathematical impossibility. Got it?
If you want more information, Trader Mike has a great article on expectancy. But basically, you need to have expectancy on your side over the long term. Otherwise you lose. Period.
For those of you that are visually inclined, here’s a chart from The Chartist, Nick Radge that lays it out:
Essentially, if you have a low percentage of winning trades, your winners must be much bigger than your losers (trend following). On the other hand, if you have a very high percentage of winning trades, your winners might be the same magnitude of your losses (mean reversion). As I understand it, these are two general ways to achieve positive expectancy.
But keep in mind these statistics play themselves out over a series of trades. You must have a big enough sample size. And if your approach is only marginally profitable, you’re likely to have big strings of losers – so it’s best to try and be deep in positive expectancy.
So now that you’re introduced to the concept of positive expectancy, what do you do next? If you are starting to see the importance of this concept, you’ll want to read Nick Radge’s free e-book. He explains this concept better than anyone, and provides key steps you can take to build your own positive-expectancy trading strategies. Thanks Nick!
Seriously, this is important stuff. I wish I had found Nick’s writing years ago – and I hope it speeds up your learning.