Reader Jeff asks a question I get a lot.

Hello Gary,

I'm a bit confused on the logic behind setting stops at 4% and locking-in gains at 3%.  Seems to me that even the best of systems (such as yours) will inevitably produce more losers than winners over an extended period.  Seems to me that risking 4% to gain 3% won't work well over time.  Perhaps I'm missing something here?

Thanks again for the great insight and daily picks.

Jeff

First off, Jeff, the 3%/4% is just a suggestion, not an ironclad rule. 

That said, tackling it anyway, points out the true equation you’re solving for and that’s “expectancy.”  That is, your profitability is in part determined by your winning and losing percentages (in this case the 3 and 4%), but ALSO the percentage of times you win and lose.

This then boils down to basic algebra: (winning percentage x % taken on winners) – (losing percentage x % taken on losses) = expectancy.

Okay, now once we know that, let’s put some numbers into the equation and assume with our 3% target, I am able to capture winners, 70% of the time.  That means we have losers 30% of the time. 

That now makes our expectancy equation: (70% x 3%) – (30% x 4%) = .9%.  So essentially, we can expect to make – over a number of trades -- .9% per trade. 

Now, what happens if I switch the numbers around, making my target 4% and my stop 3%?  Well, I’d expect to have LESS winners, right?  And if that drops low enough – say to 40% -- I’d have a negative percentage!

You can now see that an almost infinite number of different combinations can yield a positive expectancy, so keep your eye on both the targets AND how often they’re hit!