VAN K Tharp is a professional trading coach featured in Jack Schwager's Market Wizards. He is the author of several books including the trading classic, Trade Your Way to Financial Freedom. Tharp often stresses trading issues that others overlook. One of these is expectancy. "Your trading system should have a positive expectancy and you should understand what that means," he says. "The natural bias that most people have is to go for high probability systems with high reliability. We all are given this bias that you need to be right. We're taught at school that 94% or better is an A and 70% or below is failure. "Nothing below 70% is acceptable. Everyone is looking for high reliability entry systems, but expectancy is the key. And the real key to expectancy is how you get out of the markets not how you get in. How you take profits and how you get out of a bad position to protect your assets. It refers to the amount you'll make on the risk you take. If you have a methodology that makes you 50c or better per dollar risked, that's superb. Most people don't." As to the formula: Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss). So that if a trader has a system that produces winning trades 30% of the time and average winning trade net 10% while losing trades lose 3%. On every 100 points traded the expectancy is (0,3 * 10) - (0,7 * 3) = 0,9. The fact that it is positive means that even though that system produces losing trades 70% of the time the trader can still make money over time. "The interesting thing is that most of us would feel better with a system that produced more winning trades than losers. The vast majority of people would have a lot of trouble with this result because of our natural tendency to want to be right all the time. Yet the percentage of winning trades is not the most important factor in building a system." Another important consideration for Tharp is position size relative to equity size. Using the analogy of hiding behind a large wall of snow in a snowball fight, he argues that the size of the wall is an important variable. "If too small, you can't avoid getting hit. If massive, you are relatively safe. Now imagine there are two types of snowballs: white ones that simply stick to the wall and increase its size (winning trades) . black ones that make a hole in the wall (losing trades). "What would happen to your wall if it was hit by an enormous black snowball, or too many small ones?" "Expectancy, position sizing and other aspects of money management are far more important than discovering the holy grail of stock picking," says Tharp. "Having a system that gives you a positive expectancy should be in the forefront of your mind when putting together a trading plan. If you are risking over 3% of your trading capital then you are a `gunslinger', and had better understand the risk you are taking for the reward you seek." MICHEL PIREU:
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