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The recent volatility is a good reason to take pause, and conduct an audit of our trading systems.
Trading systems need not be embedded in concrete. Rather, they need to be flexible enough to bend and sway a little when market conditions warrant; but not so much so that rules are constantly adjusted to match the market on the fly.
In the first case, how much flexibility is too much? And in the second – how do we know when are ‘curve fitting’ our system to past results?
At the end of the day, a trading system is only valid if the rules of the system are adhered to. If we are not going to follow the rules, we should not expect to REALLY know whether our system is fundamentally sound – or flawed. So despite possessing the ability to create a robust and effective system, the trader’s discipline is equally important in the system’s ultimate success or failure.
Today begins a series of MarketPulse articles which will attempt to address these issues, and others, in what should be a checklist for setting up a trading system and a set of parameters for periodic system review.
What’s a trading system?
In its most basic sense, a trading system is simply a set of rules which determines how we act in the market. It will have a set of criteria that determines how and why we would enter a trade, what we do once we are in the trade, and finally, how and why we exit the trade.
It will also consider how much we intend to risk on each trade as well. Often, this is far more important than how we enter the trade in the first place.
Before we go into the aspects of determining the components of a trading system and capital management, we first want to talk about some broad concepts to help us understand the need for a trading system.
Do you know your expectancy?
Do you realise that if you don’t know your expectancy, you don’t actually know whether you are a profitable trader, or are possibly doing more harm than good by attempting to manage your own money! Expectancy is the single most important concept in understanding whether a trading system is worth pursuing or tossing on the scrap heap of broken trading ideas.
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So what is expectancy?
Expectancy is simply the average amount you can expect to win or lose per dollar you risk per trade. Here’s the formula:
E = (PW x AveW) – (PL x AveL)
- E = expectancy
- PW = probability of a win
- AveW = Average win
- PL = probability of a loss
- AveL = Average loss
Let’s say for example, Alice flips a coin to determine whether she should buy or sell. Heads, she buys – tails she sells. It turns out that this system produces winning trades 50% of the time. Alice places $1 on each trade.
Alice is disciplined enough to cut her losses at 50c when they occur, but also to let her profits run to $1 should she get into profit. She places $1 of capital in each trade position.
Therefore, the Alice’s expectancy is:
E = (0.5 x $1.00) – (0.5 x $0.50)
E = $0.25
So, each time Alice does a trade, she can expect to make a $0.25 profit for every dollar she risks – or 25%. This doesn’t mean that she automatically makes 25% on each trade. It just means that on average, over many trades, this is what she should expect from each trade.
Think about this for a second. We’ve just demonstrated that flipping a coin, and taking a 50% loss, whilst taking a 100% profit would on average, make you 25% before commissions over many trades.
With performance like that, it makes you wonder why people have so many technical indicators on their screen! We’ll lend you a dollar coin and you can get started straight away!
Now, of course, it is not as easy as that – if it was, we’d all be millionaires. But, this example hopefully illustrates some very important points in constructing an effective trading system:
1. The system needs a set of rules to determine entry,
2. The system needs a set of rules to determine how we take profit,
3. The system needs a set of rules to determine how we take losses,
4. Preferably, the amount of profit we take should be larger than our losses,
5. If we have a system with positive expectancy, we need to trade in a market which gives us as many opportunities as possible.
(There are others but we’ll run with these for now!)
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Importantly, from the coin toss example, traders should note that strike rate does not factor highly in this equation. The above example only had a 50% strike rate, yet on average over 100 trades, this system would make you $250,000 if you used $10,000 equity on each trade.
In fact, the strike rate could fall to as low as 33% and still break even.
Obviously, the higher the strike rate, generally the better your outcome is likely to be. But, what would you prefer – a trading system which had a 90% strike rate and made you $100,000 on you winners, but lost you $100,001 on your losers? Or a system which had only a 10% strike rate and had the opposite outcome?
Profitable trading is all about expectancy – not just strike rate. I wish I had a dollar for how many times a punter has asked me “So what’s your strike rate?” It’s just not relevant, or at least not the most relevant determinant of the success of a trading system.
Before we move on, there are also some potential flaws in our system, regardless of expectancy, which we need to consider:
1. What happens during a string of losses? (Yes, we have a 50% strike rate, but what if we get the first 50 out of 100 wrong before getting the next 50 right!?)
2. How do we know in advance our system works? (How can we trust the system and keep plugging away if we get a string of losses?)
We’ll talk about each of these points, and other points about what constitutes a good trading system in further detail in next week’s MarketPulse. In the mean time, I hope I’ve whet your appetite for learning more about trading systems!