Well bro, don’t think I can learn you anything but I dare say you can expand my knowledge so lets see if I can provide a different approach.

So how can expectancy be used to calculate risk. Well I’m no teacher but I’ll apply the logic to two systems, one I’m trading, one just progressed into the live forward testing. So first to calculate expectancy we need some hard data. Two ways to obtain that, exhaustive back testing or exhausted forward testing. Of cause nothing beats forward testing in a live account but many don’t make it to this stage.

So those who know me know that I have a once a day tick trade strategy on the EURUSD. Last year It yielded 68 winners @ 10 pips and 52 losers @ 10 pips. This year its evolved and now I have secured 15 wins for 205 pips and 6 losses for 47 pips. Totals 141 trades, 83 winners - 885 pips, 58 loses at 567 pips. So I had 59% winners at average of 10.6 pips, 41% losers at 9.7 pips. Knowing pip value is important as it all starts with knowing what your system can deliver un-leveraged.

So the formula for expectancy is

(% winners * avg win) - (% losers * avg loss)

In my case

(0.59 * 10.60) - (0.41 * 9.7) = 2.3 pips.

So over the course of my trading year I’ll make 200 trades at expectancy of 2.3 pips can expect a return of 460 pips. So on a un-leveraged account of $10 000 USD traded at 0.1 lots yields a return of $460. Less my trading cost (comm at 70c in/out) $140 and net profit of $320 or 3.2%. Man that’s just not worth the head !@#$. So I apply leverage to help out. Industry standards suggest that 5:1 is the max we should use but my ballz are slightly bigger so I’ll use 10:1. So now I’m trading with one lot. End result nett return $3200 or 32%. Now that’s worth my time. But just as leverage multiplies my earnings it also does the same for my loses. Lets explore that.

Now as a stand alone trade this represent a $97 loss, just less than 1%. Nothing to sad there. But what about a losing streak, what sort of draw down can I expect. Now there’s a fairly simply formula we can use to predict losing streaks. I forget where I got it but it seems to work.

CL = ((log n / -(log p)) +1

where CL = Max consecutive loses

n = Trades in sample size

p = Percentage Losing trades

So over the course of a years trading, n =200, p = 0.41 so

cl = (log 200 / - log 0.41) +1

cl = 6.94

I can therefor expect to loss 7 trades in a row once a year. Total just under 7% quite manageable.

But we all know trading doesn’t quite work that way. What if I’m hit with a 1 in 10 year event, what to expect then. Now over 10 years I’ll make 2000 trades so plug that into our formula and I’l expect 10 consecutive losing trades. Now the markets a ***** so this one in 10 year event undoubtedly will be followed by my annual event and I’ll suffer 16 consecutive losing trades. A draw down just under 16%.

Now I believe that’s quite manageable. I actually use 20:1 leverage with this system so can expect a 32% draw down at any point.

Now for my second system. This has gone through many hours of back testing by myself and a third party. Results from last year where 63 trades, 42 winners (66.7%) @ avg 105 pips, 21 loses (33.3%) @ avg 90 pips. Lets plug those figures in un-leveraged.

Expectancy = (0.667 * 105) - (0.333 * 90)

= 40 pips

So over a year my expected return is 67 trades * 40 pips = 2680 pips or 26.8%. If I applied 4:1 leverage my return now tops 100% a year, man that sounds good.

So lets look at loses. At 4:1 leverage a single trade risk 3.6% of my account. My once a year event would then calculate as

(log 67 / - log 0.333) + 1 = 5 consecutive loses

Thus expecting a draw down of 18%, not bad. My ten year event should be 7 consecutive loses therefore my black swan event can be expected at 12 consecutive loses or exposing me to a draw down of 43%.

My ballz are big but they’re not quite that big. Best I reduce my risk to 2:1 leverage. Still going to return 54% for the year but now I only risk 1.8% and can expect a 21.5% draw down.

Hope that makes a bit of sense bro. Of course there’s a few more variables one must include like currency conversions ( I have an AUD account, these calculations are based on an USD account) or if your trading the system in a basket. But I hope you get the jest of it.

Keen to heard your thoughts particularly where errors might occur