Top traders think in terms of probabilities.

While they would like to be right on every trade, they realise that is not possible – some trades are going to be losers, no matter how good their market analysis is.

What is important is that over a series of trades, they make more profits on the winning trades than what they lose on the losing trades.

This is called having an ‘edge’ over the market.

An ‘edge’ gives you a statistical advantage over time.

The first step in developing your edge is gaining an understanding of basic probabilities related to trading.

This is key to how you will think about trading.

I’ll take you through it in this lesson.

Trading with an edge

Have you ever wondered why casinos are so profitable?

Every day, tens of thousands of bets are made, some of which the casino will naturally lose.

But at the end of the day, the casino always comes out in profit.

This is because casinos have the statistical ‘edge’ over punters.

The casino has carefully designed all games so that over a long enough timeframe, the house will always win.

You can think about your trading like this too.

The role of entries and exits in successful forex trading

To continue with the gambling analogy, each trade you make is like a draw from a lucky dip.

The better your entries and exits, the more winners there are to pick in the lucky dip.

The more winners available, the easier it will be for your trading strategy to meet your objectives ie. to make a profit.

Your job as a trader is to add winning tickets to the lucky dip draw.

More importantly, you want to add in more tickets that win bigger amounts, so you come out making a profit over time.

This is what the house does at the casino. They stack the draw in their favour so that over the long term, they are guaranteed to win.

When you grasp this concept, you will realise how entries and exits fit into the bigger picture of your trading strategy.

You don’t need a perfect strategy, rather you need one that produces enough winners to pay for the losses with some profits left over.

Are high-probability entries the best ones?

When developing a trading strategy, it’s important to understand that probabilities may not be what they seem on the surface.

To the less-experienced trader, a high win rate may be seen as the most desirable.

After all, wouldn’t it be great if 90% of the trades you place are winners?

To explore this concept further, let’s take a look at three examples of trading strategies.

Strategy 1

Strategy 1 generates 10 trades a month with a 90% win rate. Winning trades make $10, and losing trades lose $100.

Strategy 2

Strategy 2 generates 10 trades a month with a 60% win rate. Winning trades make $150, and losing trades lose $100.

Strategy 3

Strategy 3 generates 10 trades a month with a 30% win rate. Winning trades make $500, and losing trades lose $100.

Before you read on, which trading strategy would you prefer?

Strategy results after one month

Here are the results after a month’s trading for each strategy (in dollars):

• Strategy 1, with a 90% win rate, had a $10 loss
• Strategy 2, with a 60% win rate, had a $500 profit
• Strategy 3, with a 30% win rate, had a $800 profit.

What do you notice here?

The strategy that made the most profit had the lowest win rate.

The strategy that lost money had the highest win rate.

When you develop your entry and exit rules, the one with the most wins is not always the best.

Be careful not to fall into this trap.

What you are after is the one that gives you the biggest edge, or in statistical terms, a ‘positive expectancy.’

To work out your expectancy, it’s first important to understand R-multiples.

Understanding R-Multiples

The information here about expectancy and ‘R-multiples’ is based on the original work of Dr Van Tharp.

R-multiples are a way of defining the initial risk you take on a trade, by thinking in terms of risk/reward.

If you place a trade with a stop-loss 50 pips away from the market, and you buy a standard lot, then your loss would be (roughly) $500 if the trade went against you.

This initial loss of $500 (or 50 pips) is your 1R risk.

The R, of course, stands for risk.

Here is how you calculate your R-multiples:

First work out the value per pip (such as $10) then calculate the distance to your stop-loss (such as 50-pips). 

Then times the value per pip by the distance to your stop-loss. This is your 1R)

Here is the formula:

(Value per pip) x (distance to the stop-loss) = R

You can express your trades in terms of R, instead of in terms of dollars.

For example, if you place a trade that risks $100, and you make $200, you have made 2R (two times your risk).

If you lose $100 you would have lost 1R.

Here are some more examples of communicating profits or losses in R-multiples:

If you talk to a trader who uses R-multiples, risking $100 per trade, who just made $240, they may say: “I made 2.4R on this trade.”

I learned this concept directly from Dr Van Tharp himself at a course I attended.

Dr. Tharp put marbles in a bowl with a number taped on the outside of each marble such as –1, 2, 4, 10.

We pulled these numbers out of the bowl to represent the results of our trading system.

For example, the –1 marble represented a losing trade, while the 2R marble was a winning trade that made two times the risk.

Since that time, I no longer think in terms of pips, rather I think in terms of R’s.

This was a key shift in my mindset, and it is a cornerstone of how I think about trading.

What is expectancy?

Market Wizard Dr Van Tharp said:

“The expectancy is really the amount you’ll make on the average per dollar risked.

If you have a methodology that makes you 50 cents or better per dollar risked, that’s superb.

Most people don’t.”

Expectancy is how much on average you are likely to make or lose when you place a trade in terms of your risk/reward ratio.

An expectancy above zero means you have a positive outcome.

For example:

• if you make on average $1.20 for every dollar you risk, then your expectation of profit would be 1.2 times your risk.

In this case, you have an expectancy of 0.2 (positive).

• If you make .80 for every dollar you risk, your profit would be 0.8 times your risk.

In the second case, your expectancy would be -0.2 (negative).

You calculate the expectancy of your entire trading strategy by averaging the risk/reward over a series of trades.

How to calculate your trading expectancy

To calculate your expectancy, first add up the total R-value of your trades.

Then divide this total by the number of trades you have made.

Here is the formula:

(Total R) / (Number of Trades) = Expectancy

For example:

If you had placed 30 trades and earned 45R in the process, your equation would look like this:

25R /30 = 0.83R

In this case, your system has an expectancy of 1.5R (which is very good).

Developing a winning set of rules

Part of the value of thinking about your trades in terms of expectancy is that it separates your success into two distinct components:

1. An entry and exit strategy that generates several R-multiples
2. A position-sizing algorithm that is applied on top of this entry and exit strategy

Essentially, now you have a set of rules for:

• when to enter and exit the market, and
• how much to trade

The performance of your trading strategy will depend on the combined performance of both of these elements, minus any trading mistakes you make.

To return to the casino analogy, while a casino has an edge, if they get a high roller in town, and they accept a bet that is too big for their bank and lose, then they could get into serious trouble.

This would be an example of them making a mistake with their position-sizing.

Thinking like a trader

By understanding the basic principles of statistics and probability, you are taking a significant step towards developing your own ‘edge’ in the market.

An edge isn’t about guaranteeing every trade will be a winner. Instead, it’s about stacking the odds in your favour so your strategy wins over time.

Top traders don’t chase every win; instead, they focus on building a statistical advantage gained through a disciplined approach.

This starts with learning to think like a trader in terms of R-multiples and expectancy.

In the next lesson, we will delve deeper into core trading concepts by looking at market types – the key to developing a winning forex trading system.

Lesson #3 The Key to Forex System Development – Market Types

See you there.