Understanding Risk and Profit Expectations in Forex Trading

In the world of forex trading, there are several oft-repeated assumptions, one of which is "if you don't want to take losses, it's unlikely you'll make a profit." This assumption is often accepted as truth. Another common belief is that profits should be greater than the risks taken in each trade. This is reflected in various expressions like "Always ensure the reward-to-risk ratio is greater than 1," or "Only trade with a minimum risk-reward ratio of 1:1.5," and so on.

These expressions highlight the belief that the reward should always be greater than the risk, or that the risk-reward ratio should be greater than 1:1. Many traders believe that having a high risk-reward ratio, even if the percentage of profitable trades is small, will easily yield profits. However, in reality, many successful traders set their risk greater than the expected profit. The key to success lies in having a higher percentage of profitable trades compared to losing trades overall.

Profit Expectation or Expectancy

One metric that determines the overall profitability of trading is the profit expectation or expectancy. Profit expectancy can be calculated by considering four parameters: the percentage of profitable trades (W%), the percentage of losing trades (L%), the average profit per winning trade (Av W), and the average loss per losing trade (Av L).

The formula to calculate profit expectancy is: 

$\text{Expectancy} = (W\% \times \text{Av W}) - (L\% \times \text{Av L})$

This gives an idea of the expected profit from a series of trades. Before applying a trading system live, it is highly recommended to backtest it on a demo account, with at least 50 trades.

Example Calculation

For instance, after backtesting for 6 months with a total of 900 trades, a trader A finds:

• W% = 70%
• L% = 30%
• Av W = $200
• Av L = $420

Then, trader A’s profit expectancy is: 

$(0.7 \times \$200) - (0.3 \times \$420) = \$140 - \$126 = \$14$

Thus, trader A can expect a profit of $14 per trade. Over 100 trades, this translates to an expected profit of $1400.

Realistic Profit Expectations

It is important to note that trading results do not always match profit expectancy. However, backtesting provides traders with a realistic picture of the potential profit from their trading system. Focusing solely on the risk-reward ratio without considering the overall percentage of wins and losses can lead to suboptimal trading results.

Ideally, the risk-reward ratio should be greater than 1:1, and the percentage of winning trades (W%) should be greater than the percentage of losing trades (L%). However, in reality, market conditions can influence trading outcomes. The key is to understand the win and loss percentages by backtesting the trading system to get a realistic view of profit expectancy.

By understanding and calculating profit expectancy, traders can set realistic expectations and improve their trading strategies for better performance.

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