I was going through some old articles that I’ve saved over the years and I came across two gems written by Gary Smith way back in 1999. One is on expectancy and the other is on the concept of thinking of the equity in your account the same way that a retailer thinks about inventory.
First of all, let’s talk about expectancy. The formula for expectancy is:
(win rate X win percentage) – (loss rate X loss percentage)
Smith gives an example of two traders — Lotto and Ergo:
Lotto stinks as a trader. When Lotto goes long, Ego goes short. Lotto’s so bad, in fact, his success rate is no better than 10%. But every once in a while, he stumbles across a winner. A big winner, which he has the perseverance to ride home until he’s up nearly 50%. Even better, while he gets a lot of losers, he’s smart enough to fold as soon as his position is 4% or so into the red.
Ego, on the other hand, prides himself on having fantastic entry signals. If MACD is crossing the fast stochastic, while the ADX line is retreating to the north, then that’s his signal! And he’s almost never wrong. Want a winner? Come to him because 80% of the time that’s what he has.
Unfortunately, to get those winners he needs to grab his profits and run. No, he doesn’t wait around, but instead when his position is up 3%, he dashes. Of course, they don’t all go up 3% immediately so he needs to give them some room. But he’s not stupid, so he’ll only let them fall 7% and then he’s gone.
So, with all that, who’s the better trader, Lotto or Ego? Ironically, over the course of thousands of trades, both will come out in a dead heat. That’s right. On every trade their “expectancy” is exactly the same at 1%.
He also posts this amazing table:
Pretty remarkable, isn’t it? All kinds of win rates from 10% to 80%, but the results are the same — an expectancy of 1%.
The other Gary Smith article is about thinking about equity in an account the same way a retailer thinks about inventory. Smith gives an example of two more traders — Rich and Peter:
Rich and Peter are two successful traders. Both start the year with $100,000 of trading capital. After the first six months, they get together to discuss their results. Rich says he commits about $20,000 per trade and makes about two trades per day. And while his win rate is only 40%, when he does win, he makes a high percentage. He knows what really matters, though, is his expectancy per trade (again, see my May 28 column) and his is a very tidy 4%.
Peter agrees that expectancy is the key. He also commits $20,000 per trade, also makes about two trades per day and is ecstatic that his win rate is near 70%. However, he also knows that his big losses hurt his overall performance. Still, his expectancy is even better than Rich’s at 5%.
So, Rich and Peter are both happy. Both are making money, and they toast to the fact that while they take different approaches, both are equally successful traders. Still, Peter is a bit smug, thinking he is the slightly better trader.
But, then Peter asks Rich how much Rich has in his trading account. Rich replies that he is now up to $180,000. Peter’s jaw drops. He thought he was doing better than Rich, but his equity is only at $150,000. How can that be?
Posed this way, the answer should become clear: Rich must turn his trades more quickly than Peter. In fact, during that six-month time period, Rich’s average turnaround on his trades was only two days. Therefore, his “inventory” of equity was continually turning over, enabling him to get in 100 trades in a six-month period. With each trade yielding 4%, he made $80,000 (100 trades x 4% x $20,000/trade).
Peter, however, while having the better expectancy of 5%, didn’t employ his equity nearly as fast. He managed to close only 50 trades in the same time period, leaving him with $50,000 in profits (50 trades x 5% x $20,000/ trade).
Peter now understands. He now knows that win rate, loss rate, expectancy and profit are all secondary to profit per day. While he seemed to be the superior trader to Rich, his profit per day was only $450 (assuming 110 trading days, then $50,000/110 = $450). Meanwhile, Rich’s profit per day was $725 ($80,000/110 = $725).
So you may be thinking at this point that the answer is turning over inventory much faster. In other words, the answer is to trade on a very short-term basis. Not so fast, it’s not that simple.
Let’s look at the results of our SMR Portfolio so far. As of today, there have been 56 completed trades since 4/29/05. 76.8% have been winners and 23.2% have been losers. The winners have resulted in an average profit of 31.3% and the losers have resulted in an average loss of 9.6%. So the expectancy is:
(.768 X .313) – (.232 X .096) = 21.8%
What about inventory turnover? The average number of days to be in a position has been 132 days. So we’re turning over our inventory every 132 days.
How can we make improvements? First of all, I’m flat out embarrassed about a 76.8% win rate. That’s way too high and it gives people the impression that it’s sustainable. I assure you that it’s not. So look for it to come down.
The ratio of profits to losses of 32.3% to 9.6% is excellent — 3.4 to 1. That may be sustainable, but it’s going to be hard to make improvements there.
Where there may be an opportunity for improvement is in inventory turnover. If we could maintain something close to the same expectancy and at the same time increase inventory turnover overall profits would increase. But I would only want to increase turnover if it didn’t decrease expectancy by too much.
Smith puts it this way:
If you don’t get a handle on this stuff, you will never take your trading to the next level. It is not just about finding good trades and banging them out. And it’s not nearly as simple as “cutting your losses and letting your winners ride.”
No, there is a huge interplay between finding good candidates, win rates, expectancy, profit and profit per day.
So it’s a combination of factors that must be considered. The point is that I’m asked all the time about things like what I think about the market, or this stock vs. that stock, or technical patterns, or indicators, or the economy, or whatever. The truth is that I don’t think about those things very much. I’m thinking about money management.
Or as Gary Smith says — money management is everything.
Larry Holmes
