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We all have the need to be right. Think about when you were in school - you did your best to be right, and you were graded on your efforts. You took standardized tests to measure how right you were. All your life, you have tried to pick the right career, the right spouse, the right place to live. Everyone wants to be right.
But being right doesn't matter - at least when it comes to trading. In fact, trying to be right by having a high percentage of winning trades is usually a recipe for disaster.
When evaluating trading systems, many people first look at winning percentage (degree of "rightness"). They will, out of hand, dismiss any system below their objectives, which is typically 75% wins or higher. Worse yet, many people will try to be right by refusing to take a loss. Unfortunately, losses left open tend to get larger and larger, making the situation even worse.
Why is looking at winning percentage alone dangerous? Perhaps an example will help. Take 2 trading systems - in trading system A, 90% of the time you win $1. The other 10% of the time you lose $10. In trading system B, 10% of the time you win $10, and 90% of the time you lose $1.
Most people will select system A, since it wins 90% of the time. After all, who can handle winning only 10% of the time?
While it is true that low winning percentage systems are hard to psychologically handle (it is not easy being wrong 9 times out of 10), sometimes those are better long run systems.
How do you know? A simple calculation called "expectancy" tells you. Expectancy is calculated as follows:
Expectancy = ( % win * avg win $) + ( % loss * avg loss $)
% win = winning percentage, expressed as decimal
avg win $ = dollar value of average winning trade
% loss = losing percentage, expressed as decimal
avg loss $ = dollar value of average losing trade (must be less than zero)
To standardize it, many people then divide this number by the absolute value of average loss.
The important thing with expectancy is that if it is less than zero, YOU HAVE A LOSING SYSTEM. Look again at the example above. Trading system A has a negative expectancy, but system B has a positive one.
If the long term expectancy of the system or method you are trading is less than zero, you will eventually lose all your money - guaranteed! One example - every game in Las Vegas has a negative expectancy for the player.
So look more at expectancy, and less at winning percentage. It is no fun being right most of the time if if leads to the poorhouse.
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