How to diagnose the health of your trading plan

One of my kids just doesn’t ever get sick. I can think of just 2-3 instances where he was curled up on the couch, but never more than a day. It’s pretty black and white to tell if he’s feeling sick. Almost checklist easy.

Is he laying down on the couch/chair instead of running around? Yup.

Does he have a low grade fever? Yup.

Is he not eating much? Yup.

That’s pretty much all we need to know to tell if he’s sick. But he’s got a strong immune system and it never lasts more than a day because he’s always back to running around like crazy the next day.

But how do you know if your trading plan is sick?

You can’t see it laid out on the couch or pull out a thermometer to check its temperature. The best most people can do is pull up their profit/loss numbers and see where they stand. But this doesn’t tell you about the health of your plan, just where you currently stand.

Today, we’re going to take a first step in diagnosing the health of your trading plan and in the future we’ll look into how to deal with any problems found.

 

Stumbling in the dark

When I started trading a few years ago I was stumbling along in the dark, hands flailing out in front of me trying to find my way. I followed no real plan to speak of beyond trade…just trade.

I never knew what to expect from one trade to the next. Was it going to be a winner? A loser? Was the next trade going to wipe me out?

During my second year of trading I developed a bit of a plan and somewhat executed on it, however I still couldn’t predict from trade to trade where I was going. I bought the Trading Journal Spreadsheet and found myself swimming in data with no real understanding of what most of it meant to me.

I didn’t take the time to understand what I was seeing so I only pulled from it profit/loss tracking. This gave me an answer to “am I winning or losing” but it changed with each trade I made. I had no real expectation for what the next trade would bring if I followed my plan.

One of the days I deliberately digested the data on the TJS analysis page and I noticed a field called “expectancy.” As I hovered over the little red triangle in the Excel field, the following definition popped up:

Displays your expected return based on each sub-category and its historical average per trade.

Expected return? Hummm…

Okay, so if we remove “each sub-category,” since it’s particular to the field, replace it with “your trade system” and remove “Displays” just because it’s extra we get this:

Your expected return based on your trade system and its historical average per trade.

That sounds like pretty good information to know!

I was curious to find out how to determine this number, its reliability, and what it really meant for my trading.

 

Expectancy – how to figure it out

Expectancy…we’re not talking about how long you’ll live or what the insurance companies use to determine your life insurance rates.

No, what we’re looking at is what you can expect to earn from your current trading system based on a few bits of information.

I dug around the web for a common definition for this concept and really couldn’t come up with anything better than what I have above:

Your expected return based on your trade system and its historical average per trade.

I’m sure I missed a page somewhere or there is a more technical definition for this concept, but for me it works perfectly.

What I really wanted to know is how this number is created. What were the mystical ingredients did I need to throw together to arrive at this mysterious number? And did I need to clean the webs off parts of the brain which learned (and quickly forgot) calculus to figure this number out? If so, that could be a show stopper…

Much to my surprise (and relief) it’s composed of four basic parts and only requires the most basic of algebra to figure it out. The best part is, if you’re keeping a good trading log you’ve got easy access to this calculation. Better, if you’re using the Trading Journal Spreadsheet, it’s done for you!

Here’s the basic formula we’ll break down:

Expectancy = (win percentage * average win) – (loss percentage * average loss)

Let’s tackle the easiest parts first…average win/loss. Figuring out these numbers is pretty straight forward. Go through all of your trades and tally up your net income on your wins and losses separately.

Next divide each by the total number of trades for each category and you’ve got your average for each.

For example, if you have 20 trades total with 8 losses totalling $100 and 12 wins totalling $240 your average win would be:

Average win = $240/12 = $20

And your average loss would be:

Average loss = $100/8 = $12.50

Awesome.

Ok, onto the percentages. Don’t let the word “percentages” scare you away. I’m sure you’re having a horrible flashback of some statistics class, but it’s not going to be that bad…I promise!

Calculating these is just as simple as figuring out your win/loss averages. All you need to do is collect the total number of wins, the total number of losses and the total number of trades, then you’re ready to rock.

Divide the number of wins (or losses) by the total number of trades to arrive at the percentage for wins or losses.

So, building off our previous example we have 12 wins and 8 losses totalling 20 trades. We’d determine our win percentage like this:

Win percentage = 12/20 = .6 or 60%

And your loss percentage would be:

Loss percentage = 8/20 = .4 or 40%

Okay. Now we’ve got the ingredients to figure out the expectancy…let’s put it all together.

Expectancy = (.6 * $20) – (.4 * $12.50) = $7

Sweet! We’ve got our expectancy figured out! So…what does it mean?

 

Expectancy – how to use it

Let’s return real quick to our expectancy definition:

Your expected return based on your trade system and its historical average per trade.

As with many things related to securities and trading this number will tell you a future expectation based on past performance…it’s not a guarantee and will adjust up or down with each trade.

Our particular example tells us we can expect to earn $7 per trade as long as we continue to follow the same trading system and achieve similar results.

What if the numbers worked out to equal -$24? Would your trading system be worth continuing?

Nope, but it would give you a good starting point for figuring out what’s wrong.

And that’s the primary purpose for determining expectancy, diagnosing the health of our trading system.

The result of the formula, positive or negative, provides a basic diagnosis of our trading system. The parts we used to determine expectancy are the individual “symptoms” we can further examine to get us back to “healthy” or to strengthen our system.

Exactly how we break that down will be covered in another post and get us started down the road of figuring out how we can revive a dying trading system or make a healthy one stronger.

Take a shot at figuring out what your current expectancy is and leave a comment below to let everyone know how awesome you’re doing!