How to convert a negative expectancy trading system into a positive expectancy one | Hedging Magic
Hedging is a risk management strategy used in trading and investing in protecting against losses. Hedging works by offsetting the risk of loss from one investment by making another investment that will move in the opposite direction.
Let's take an example of how creative hedging can ensure positive expectancy from a negative expectancy trading system.
In this blog post, we'll take a look at what expectancy is and how it can be used to improve your trading results. By the end, you should have a better understanding of how to approach trading with an expectancy-based mindset.
Expectancy is a statistical concept that measures how much you can expect to win or lose on average per trade. It is calculated by taking the average profit per trade and subtracting the average loss per trade.
Let's assume that you have a trading system that has the following metrics:
- Win Rate = 30%
- Reward : Risk Ratio = 1.5 : 1
This means that of every 10 trades that you take only 3 have a win.
And you win 1.5 times the money you lose.
Let's say you are betting $1000 on each trade with a 10% stop loss. So you lose $100 (risk) when the trade goes against you and hits your stop loss and you win $150 (1.5x of the risk) when the trade goes in your favor.
So the expectancy of this system is now:
E = 30% * $150 - 70% * $100 = -$25
This is a negative expectancy trading system, meaning on average you will lose money with this trading system. This is clearly not a good trading system.
But here comes the power of hedging. Let's say that every time you place a LONG bet on the above trading system you also take a SHORT position on the opposite side with a basic target 1:1 reward : risk ratio of equal risk side as that of the LONG.
Now, when the LONG trade goes in your favor you make:
$150 (LONG) - $100 (SHORT) = $50
And when the LONG trade goes against you, you make:
$100 (SHORT) - $100 (LONG) = $0
What is the expectancy then of this hedged system:
E = 30% * $50 - 70% * $0 = $15
Now, this is a positive expectancy system, which on average will make money.
So with the creative use of hedging, we can convert, in theory, any negative expectancy system into a positive expectancy one.
But one of the key requirements here is that the trading system should have a positive reward:risk ratio i.e. (>1).
This is the magic of mathematics!
DISCLAIMER: This is not investment advice.
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