Calculate Your Expected Reward

July 9, 2010

Are the rewards you are getting worth the risks you are taking?

As astro-traders it's easy for us to get caught up in our market analysis, marveling at the way that astrology can so accurately predict the turning points in the price patterns of stocks and commodities.

But trading is about more than just analysis and research. If we are going to be profitable in the markets, we must be active in the markets, so we must constantly be on the lookout for opportunities to put our money at risk.

And when you risk your money in a trade, what kind of reward can you expect?

That's a critical question each of us must answer as astro-traders, and the answers depend entirely on our individual trading experience. That's one of the reasons why it is so important to keep records of every trade we make. As we look back over the cumulative statistics of our wins and losses, we can not only gain insights into the foolish mistakes and remarkable successes that give us great stories to share; we also have the raw material for a detailed and sober analysis of exactly how much reward we can expect from our trading activity.

Nauzer J. Balsara created a simple equation that gives us a way to measure exactly how much return we should anticipate, based entirely on our own individual trading performance:

(PW * AW) - (PL * AL) = ER

where PW = the Probability of Winning; AW = the Average amount of a Winning trade; PL = the Probability of Losing; AL = the Average amount of a Losing trade; and ER = our Expected Reward from future trades.

Take a look at the records of their previous trades. Calculate the percentage of winners and the percentage of losers. Determine the average amount of each winning trade and of each losing trade. Then plug those numbers into Balsara's equation, and you'll find out what your expected reward is.

For example, let's say you have taken 100 trades, with 40% winners and 60% losers. If your winning trades average $600, and your losing trades average $225, the equation looks like this:

(40/100) * ($600) - (60/100) * ($225) = ER
($240) - ($153) = ER
$87 = ER

So, based on your previous trading experience, you can expect a net profit of $87 per trade in the future. Take another 100 trades, and you can look for a net reward of $8,700.

As astro-traders, we must always be ready to take losses, and to take them quickly. We are likely to have more losing trades than winning ones, no matter how good our analysis is. But if we know the statistical probability of an exact Expected Reward, we are usually much more willing to remain disciplined in taking regular trades and turning our encounters with the market into a profitable business.

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