An edge can also be referred to as a positive expectancy.
My aim and I'm sure this is the aim of all those that design and develop trading systems, is to develop a model which has a mathematical positive expectancy.
Having a system with a positive expectancy basically means that over the long run, over X number of trades and N number of years, the system will make money.
The formula for Expectancy is.
(Average win * Percent winners) - (Average loss * Percent losses).
This figure, if positive, tells you how much you will make, per trade.
Expectancy can also be calculated as a % per dollar risk.
Now "per trade" is the key part, and this is something that I only fully understood a few days ago.
I was testing two systems, both systems were exactly the same, and what I was trying to do was optimise the ATR multiplier.
When I was testing the system with a 2.5*ATR trailing exit, these were the relevant stats.
- Average win/Average loss = 5.4654
- Percent winners = 42%
- Average profit per trade = $1,285.02 (Expectancy)
- Annualised compound interest rate = 22.6859%
When testing with a 2*ATR trailing exit, these were the relevant stats.
- Average win/Average loss = 3.0486
- Percent winners = 49%
- Average profit per trade = $754.89 (Expectancy)
- Annualised compound interest rate = 31.5157%
Now, note how both systems have a positive expectancy. The first system has a greater expectancy than the second one YET the rate of return of the second system is much higher.
Why?
(Note that even though system 2 has more percent winners than system 1, this is taken into account when working out the average profit per trade)
The answer to the WHY lies in what i was highlighting before.
Trade frequency.
System 1 in fact made only 109 trades in the testing period (6 years).
System 2 made 247 trades.
In summary, whilst its crucial to trade a system with a positive expectancy, its also important to keep in mind that trade frequency is what determines how often you can exploit that edge.
Its useless having a system that picks 80% winners and has an average win/average loss of 12 if it only trades 8 times a year.
Van Tharp's Trade Your Way to Financial Freedom is one of the best texts I've read on the topic of expectancy.
2 comments:
Nizar,
Expectancy is not what it seems to those who believe in the historical insurance blanket.
Expectancy does not guarantee what a trader can receive. It is only a guide on history that can be applied to the future expectation, not guarantee, and is in no way the edge, nor is it concrete in terms of returns.
Hi,
Thanks for your comments.
I agree with this:
"Its only a guide on history that can be applied to the future expectation".
Obviously there are no guarantees or certainties in trading. Just probabilities, opportunity and the ability to act on them.
I'm not sure what you mean by "The" edge. Can you please elaborate on what you mean by: "Expectancy... is no way the edge..." Surely having a system that has, historically, through robust testing methods, traded with a positive expectancy, gives you some sort of edge ?
Maybe my understanding is flawed.
Hmmm, you have got me thinking.
Is that you Nick!?
Thanks for dropping by.
Nizar.
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