Expectancy vs Risk/Reward

This is a really important topic as expectancy is an important factor in trading when assessing your risk. Risk reward is a straight forward topic and most traders are very familiar with the concept.  However, what is expectancy? In short, expectancy is the likelihood of an event happening. So, let’s have a simple example. The expectancy of the sun rising tomorrow.

The expectancy of a sun rise

If someone says to you, ‘what are the probabilistic chances of the sun rising tomorrow?’ What would you say? Well, I would say the chances are very, very high. Our expectancy that the sun will rise again tomorrow is high. Therefore, would we be prepared to risk £1000 to make only £20 on that wager? The answer would most likely be ‘yes’! Now from a strictly ‘risk vs reward’ scenario the wager does not make sense at all! I am risking £1000 to only make £20. That is a rubbish risk vs reward wager! However, when you factor in the probability of the sun rising again tomorrow it makes sense from an expectancy point of view. What are the chances of the sun rising tomorrow? It has got to be 99.999% right? Now, for the sake of argument, let’s just say that the expectancy of the sun rising tomorrow is a mere 99% chance. From an expectancy point of view it still makes sense. The risk vs reward is terrible, but the expectancy is positive. This means the wager makes sense mathematically. Here is the calculation I use when I am working out expectancy. See below: 

How this applies to trading 

So, this means if you think an event has a very high probability of occurring then you don’t need a positive risk vs reward scenario. Now, the ideal is that you have both, but you don’t have to. You just need to correctly assess the probability of an event occurring. Now, that can be trickier than it sounds, as how do you accurately assess whether something has a 60% chance of happening vs a 65% chance? This can involve shades of grey. However, if you lean towards the side of caution then that should mean you keep the odds in your favour. This is a concept that we can cover in more depth in my daily webinars.