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Technical Analysis - Expectancy

Fundamental analysis in commodities trading looks at economic factors such as weather predictions and crop yields, new mines opened, new oil extraction technology, etc. In short, factors affecting the causes of supply and demand.

Technical analysis, by contrast, is based on the idea that trends can be detected by charting mathematical manipulations of a few basic variables: price, volume and a few others. Most macro-economic factors are given much less weight. Actual market activity in the recent past is what is considered most important to predict future prices.

Both camps recognize that any predictions can only be made with a limited degree of certainty. Only probable outcomes can be calculated. This gives technical analysis the edge with at least one variable: expectancy.

Expectancy is a powerful trading tool and one that isn't used often enough by novice traders. Yet, expectancy is simple to understand and calculate.

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)

Suppose an investor has (by whatever means) enjoyed profitable trades only 30% of the time for the last year, and the average trade profit was 10%. Losses were on average 3% of the amount invested, $10,000. Therefore:

Average profit = 0.10 x $10,000 = $1,000
Average loss = 0.03 x $10,000 = $300

So,

E = (0.30 x $1,000) – (0.70 x $300) = $300 - $210 = $90.

Observe that even though the percentage of losing trades (70%) swamped winners, the trader still sees a net profit of $90 for the year. Not huge, but still not a loss.

Of course, the numbers could be anything, in principle. The point of using expectancy is to help keep your eye on the ultimate goal: coming out ahead over the long term.

Psychologically, novice traders tend to focus on the number of times trades were profitable vs those that resulted in losses. Expectancy helps you focus on the important item: net profits over time.

Stock traders are constantly debating whether it's better to trade longer term vs shorter term. Non-professional day traders are often looked down on. But the situation in commodities is just the reverse. Short term positions, even for relatively inexperienced traders, generally lead to better results.

It's difficult for most non-professional traders to accept losses. They tend to stay in the market too long, hoping for a turn around to eek out a profit, or at least minimize the loss. In many cases, with stocks, that will work out. Commodities are different.

Remember, the longer you stay tied to a position, the longer you have your capital tied up - capital that could be making you a profit that will more than compensate for past losses. Accept the fact that you can not predict correctly 100% of the time.

Also, since most commodities trades are carried out by buying and selling futures or options contracts, you have only a limited time - usually no longer than a year, often much less - to make a decision. The closer the contract gets to its expiration date, the more likely you are to lose, on average.

Commodities trading isn't for everyone. It's high risk, fast paced and prices are volatile. But proper research and use of the wide variety of tools available will help those interested to come out a winner in the long run. Expectancy is one tool you shouldn't overlook.