To push yourself out of the Exploration Phase and directly onto the road that leads to the Gravitation Phase, which is so important, you need to start committing more time and effort to the trading styles that you’ve identified in order to find out if they really are the ones you should continue to focus on. Your instincts have led you here and you’ve trusted them so far, so now it’s time to dig a little deeper. 

After all, what is your ultimate goal? To become a consistently profitable trader, and as soon as you can. So why waste your time and efforts? 

So if you’re not already doing it now is the time to start focusing on back testing your favored strategies and determining whether or not they exhibit positive expectancy over time. If they do, then it’s another very important signal to you that these are the right strategies on which to focus and you should spend as much time as you have every day studying them and as much of the actual market day simulating (paper trading) them. Then, if you still like the strategies, you’ll want to begin trading them in the live markets at a very small amount of risk. This will keep you moving forward and ever closer to profitability.

What is positive expectancy? Put simply, it’s how much money on average you expect to make per trade over time, and it’s very important for having enough faith in your strategy so that you’re willing to take it through difficult market environments in which it will struggle. If it has positive expectancy then you have a reasonable expectation that it will emerge from tough periods and end up making more money than it loses over time. Making more than you lose over time is profitable trading.

So positive expectancy can literally tell you if you’re wasting your time. It also shows you that you don’t have to be right all the time, or even most of the time depending on the frequency of wins and losses and the discrepancy between the amounts of wins and losses. This is a very important concept for a new or struggling trader to understand. If you’ve got a strategy that makes money only 50% of the time but its winners are larger than its losers, then you have a profitable strategy over time. Let’s take a look at why this is true.

The formula for calculating the positive expectancy of your strategy is simple. Just take the percentage of time your strategy wins, or makes money, which is also referred to as the probability of profit, and multiply it by the average amount it makes each time it wins. Then take the percentage of time your strategy loses, which is also called the probability of loss, and multiply it by the average amount it loses each time. Subtract the second number from the first and you’ve got your positive expectancy. In other words:

ER = (PP x AW) – (PL x AL)

ER = Expectancy or Expected Return

PP = Percentage of the time your strategy wins, or Probability of Profit

AW = Average Win Amount

PL = Percentage of the time your strategy loses, or Probability of Loss

AL = Average Loss Amount

So you can see that even if your strategy wins only half the time making a little more money on each win than you lose on each loss gives you expected returns that are in the positive column over time. Let’s say your strategy makes $7.00 on average when it wins and it wins 50% of the time, while it loses $5.00 on average each time it loses and it loses 50% of the time. This is based on whatever risk allocation you’ve chosen for this particular strategy. Here’s how to calculate the Expected Return of your strategy at this risk allocation:

ER = (.50 x 7.00) – (.50 x 5.00) = 1.00

So the Expected Return for your strategy at this risk allocation is $1.00 per trade on average. If you trade the strategy 100 times in a year, you can expect to make $100 in that strategy for the year.

This means you don’t have to break your back trying to be right all the time. This is especially important for directional stock traders, like intraday traders and swing traders, because even if your strategy makes money only 30% of the time it will have a positive expectancy if its winners are much larger than its losers. And directional traders generally make money by cutting their losers and letting their winners run.

For instance, if a swing trader has a strategy that wins only 30% of the time but makes $15 on average for each win and loses 70% of the time but loses only $5 on average for each loss, she can still expect to make $1.00 per trade on average ((.30 x 15) – (.70 x 5) = 1.00). If she trades 1,000 times per year she can expect to make $1,000 that year from the strategy at that particular risk allocation.

With a higher win rate you can actually lose more on each loss than you make on each win and still achieve positive expectancy. This is a big deal for market-neutral options traders – also called “income” traders or “complex options spread” traders – because typically these traders employ strategies that win more often than they lose but their losers are larger than their winners. 

For instance, a typical market-neutral options trader who trades the cash indexes like $SPX and $RUT will put on an iron condor or butterfly with a plan for a profit target of 10% and a max loss exit of 12% to 15%. If he risks $10,000 for each trade and his strategy has been shown in back testing to win 75% of the time but make an average of only $1,000 on each win and lose 25% of the time at $1,500 average per loss, he can still expect to make an average of $375 per trade over time at that particular risk allocation.

So if the options trader trades his strategy 12 times per year (once per month) and can reasonably expect to have an average win-loss record of 9-3 over time at these numbers, he can expect to make an average of $375 per trade (per month) for a total of $4,500 on average each year at this particular risk allocation. This is a pretty optimistic expectation of returns, however, because the trader won’t realistically meet his full profit target on every win or hit his full max loss on every loss. So it’s more realistic for the trader to average about $750 per win vs. $1,200 per loss and make $262.50 per trade or $3,150 per year on average (closer to a 30% gross annual return). 

Don’t forget to subtract commissions if your broker charges them as well as exchange fees and other fees. You also need to consider slippage. Slippage can be defined as the difference between an individual trade’s expected price and the actual price at which the trade is filled or executed in the market. Slippage can be more meaningful to your returns than you think because if you’re getting filled at a much different – by different I mean worse – price than you were expecting it can really start to add up and negatively affect your expected results over time, especially if you trade frequently.

Positive expectancy is an extremely important concept because consistent profitability in trading is accomplished by making more money than you lose, NOT making money all the time. So this means you are going to lose money at times and you just have to accept it. If you’re making more money than you lose over time you’re a consistently profitable trader, even if your strategy actually makes money only 30% of the time as previously shown.

Remember, there is no “Golden Goose” or “Holy Grail” strategy. This is the bottom line and if you weren’t able to fully accept this in Step 2 please use this discussion about positive expectancy to force yourself to accept it now.

So I hope you’re starting to understand why this step is such an important one for keeping you moving forward and not running in place on the hamster wheel. Focusing most of your efforts on your favored strategies that have positive expectancy over time not only gets you a deeper understanding of these strategies, which leads to making them your own, but also gives you the confidence to stick with them through the hard times. 

Remember, though, that you need a large enough sample size for positive expectancy to be reliable. You can’t just conclude that a strategy yields positive results over time after just three trades. You’ve got to test and simulate your strategies over long historical periods through different market environments to know for sure. So you need good back testing software.

You can find software to back test most kinds of strategies but not necessarily all strategies. If your strategy isn’t easy to back test you’re just going to have to simulate it in real time for a while before determining whether or not you have enough faith in it to trade it in the live markets with a great degree of confidence. Strategies that are hard to back test are ones that rely on a high degree of trader discretion as opposed to those with very specific guidelines and rules that tend to be more mechanical.

If you find yourself hopping from strategy to strategy, looking for something that works all the time, this is one way to pry yourself out of it. This is how you can get yourself out of the Exploration Phase and into the Gravitation Phase. Use positive expectancy as a way to do this. Use it as that extra motivation you need to push yourself forward.

Then, as you simulate your favored strategies and transition into trading them in the live markets, make sure you’re journaling about every trade and keeping track of your results. Go back and review the details of each trade on a daily or weekly basis because this can be very important for determining whether or not it’s actually something you’re doing well or NOT doing well. When you identify trades and strategies that you are executing very well, it’s crucial information and something you can really build on. This is also how you effectively move to the next step because it helps you streamline your approach. 

Did I allocate my time and efforts effectively?

It took me a while to figure this one out so my strategy-hopping stage lasted longer than it should have. I hope by including this step I’ll help you keep moving forward instead of getting stuck in place.

I didn’t discover the concept of positive expectancy until years into my trading journey and when I discovered it I wished at the time that I had learned about it right off the bat. The concept was a powerful one for me because it focused my efforts on trading only those favored strategies that tested positively and as far back in time as possible, and it helped me start looking at losing money as just a necessary part of the game. It also helped me understand the profound effect which the overall market environment has on all strategies, which I will talk about in a later step.

As I said in the previous step, I was lucky because I had already discovered and was employing a profitable strategy when I started to really focus my efforts on the right things and allow myself to be guided by the concept of positive expectancy. I pretty much stumbled upon the profitable strategy, almost in spite of myself. But it made all the difference in the world because it showed me that profitable strategies DO exist and it gave me the confidence to stay in the markets long enough to finally develop profitable approaches in my favored strategies, which turned out to be swing and momentum trading in stocks and market-neutral options trading.

My automated strategy was in shorting VXX, which is an exchange-traded note (ETN) issued by Barclays that provides access to equity market volatility through VIX futures. In other words, it attempts to track the VIX, otherwise known as the “fear index”, and it was my first profitable strategy. It was that light at the end of the tunnel I’d been searching for. As I mentioned briefly in Step 3, I learned automated trading almost on a whim in late 2013. I’d been stuck in the strategy-hopping stage for almost two years by that time and thought I was close to hanging up my trading shoes. And when Andrew Falde started training me in automated trading I have to admit that after the first few sessions I wasn’t connecting to it.

But I realized the full value of what I was learning when several sessions into the course Andrew asked me what system I wanted to build and with what trading vehicle. Almost immediately VXX came to mind because I’d been a member of a trading room earlier that year in which the lead trader had constantly been talking about how profitable it was just to “short the VXX.” Although VXX drew a great deal of volume it was a relatively little-known product among retail traders at the time, having been issued in January of 2009 as a bond-type offering with a 10-year maturity date. When the lead trader would assert almost every day in the trading room that shorting the VXX was an almost sure way to make money, I had to follow up on it to see what the heck he was talking about.

Sure enough, when I pulled up a chart of VXX I could see why he kept recommending going short. All it did was go down. I hadn’t been trading very long but I hadn’t seen anything like it. I read somewhere and heard from other traders that it had a “negative drift” due to management costs or something like that but I didn’t really understand at the time. When I told Andrew that I wanted to see what the results of a system looked like that shorted the VXX and it came up consistently and highly profitable over time, I jumped right in to my education in exchange-traded volatility products.

I learned exactly why it had this crazy “negative drift” and started to understand why it behaved the way it behaved. And this led me to understand what market environments would be best for it and what market environments wouldn’t be so good. So I knew what to expect when I started running the automated system in the live markets in 2014. And this was the turning point because it was this system, along with a few other automated systems in gold miners and silver that year, that helped me to overcome my continued struggles with options trading and directional trading in stocks. My automated volatility systems have been profitable every year since 2014, and this has been a big deal for my trading. I was even able to secure private funding later that year for my automated short VXX system.

My point in talking about this is that it just takes one successful strategy to keep you in the markets long enough to find out who YOU are as a trader and develop your core trading approach. It just takes one successful strategy to launch a profitable trading career because it gives you the confidence you need to persevere. Without the automated VXX strategy it may very well have been too difficult for me to keep going until 2016 when I finally latched on to an options strategy that fit my personality and made consistent money. Without it I might not have been trading in 2017 when I finally developed a consistently profitable swing trading system.

Once I was making money in a strategy that I understood through and through and the concept of positive expectancy had been introduced to me, I was moving forward again and happily transitioned into the Gravitation Phase where I began the development of my core approach in automated systems in volatility, swing and momentum trading in stocks and market-neutral trading in options.