My last post talked a little about positioning both sizing and risk. If you are getting these in your email, dig through your spam folder and find the post titled “Mimicking Traders..”
This post I want to talk a little about risk and reward. There has been some discussion lately about a 1 point profit 4 point stop and if it can be profitable. The answer is yes.. but..
I do not want to get too technical here but it is important that traders have an inherent feel for some of the basic math that goes into trading. These should be in the “sky is blue” and “grass is green category”, which is to say just something you know.
Risk and reward. If presented with a mechanical trading system that is 4 point stops and 1 point gain this means for every 4 profitable trades you can only afford one stop-loss to stay breakeven. (Let’s keep commissions out of this for now). So four out of five trades must be 1 point winners, that calculates out to a 80% win/loss ratio requirement. We all get that right? If not stop here and ask someone how the math works. hint (4/5 = 0.80)
That 80% requirement puts the burden of the system on the entry. It has to be pretty, pretty good. We are talking about a mechanical system here, I will address some discretionary stuff later. I just want to work with mechanics for now.
In my strategy work getting above 66.6% (2/3) win/loss is very hard but achievable. To push those numbers above that you must accept more risk and/or be more selective in your entries. I will illustrate this with a couple of mechanical examples in later posts.
Let’s take a simple RSI long only mechanical entry. If you don’t know what an RSI indicator is go to investopedia.com and look up this simple oscillator. I will be using the RSI long entry strategy as it comes out of the box in TradeStation along with their profit target exit and stop less exit.
The entry is a cross above the oversold region. I will be using a 5 minute chart, a fixed exit and stop. I am not arguing that this is a good system, just to illustrate a point about stops. We will take profits at one point and set our stops to four points and run the simulation over four years of the continuous ES contract (S&P 500 Emini Futures) @ES day time session only. Our RSI input is set to a length of 2 and an oversold value of 2. It is very fast but selective and generates just one or two trades a day.
Results:
Below are the TradeStation results based on this simple system. It does in fact show a small profit, but on the edge. When I read this reports the following items are what I am most concerned about. Net profit of course, but profit factor (ratio) (win$/loss$) also. This system has a profit factor of just 1.09. I like 2.0+ or better yet 3.0+ systems. Our simple system took 1067 trades over the 4 years. That is about one trade per day (250 trading days per year). 77%* of the trades were profitable ( I will address this in a moment). Average gain per trade was just $4.68. This is where commissions come in.. if your commission round-turn is greater than that.. you lose. (Your broker wins though.. it you like him/her).
We will focus on those items for now. There are many great statistics here and elsewhere in the reports, like drawdown etc.but we need topics for other post so forget them for now.
*About the 77% win/loss ratio.. you told us it needed to be above 80%? In coding our system we are using the day session only ES data and are holding overnight therefore some of the overnight gains have been greater then one point profits allowing a smaller win/loss ratio to be profitable.
Here is the performance graph of our mechanical system over the four years. The green dots represent new account highs (we are happy), lack of green dots we are getting nervous.
Again, before I start getting mail about what I have not included.. (slippage, commissions etc.) I am attempting to deal with the basics here. As an aside, I personally could not deal with this system. The period between green dots, particularly the drawdown between trade 425ish and 725ish represents a year+ of drawdown (10/08 to 12/09) that would be tough to weather through.
Okay, back to point.. what if we widen our stops even further? In my earlier post I noted that with $5625 I can buy one ES contract that I can hold overnight and meet all the margin requirements. Once bought I am allowed 22 points against my position before I have to add more cash to my account (assuming I funded the account with just the $5625 minimum). So let’s use the TradeStation optimizer to change my stops from just one point to 20 point stops and see what happens.
In this image above, test number is the number of points I allow my position to run against me. Notice as I loosen my stops the % Profitable trade increases along with my net profits and profit factor. Let’s take a look at the profit graph for 20 point stops.
We end up with over 3x more profits and although my stops are much much larger, I would rather trade this system than the 4 point stop system. The period between green dots is smaller (still too large) so I am happier. While taking a $1000 loss is not fun, the stops are less frequent and my victories more abundant. Psychologically for me, this would be an easier system to trade.
So before someone tells you a 1:4 (profit to stop) ratio is bad, run through the numbers. Trading is a multi-variant problem of which risk and reward represent only two variables.
I am wrapping this post up before it runs too long and everyone goes to sleep but I want to talk a little bit about discretionary entries versus hard coded mechanical entries. When talking to new traders I often use the example of driving. Everyone can learn to drive, some better than others. In teaching or four teenage boys to drive I can tell you, those new drivers are really scary. Mechanically they get it, put the car in drive, keep it sort of in their own lane, stop at stop signs etc., but the ability to “read the road” and the surroundings just has not developed along with the subtleties of keeping your passengers at ease. Did you know that most curves in a road are a constant radius? So to enter a curve one simply needs to find the correct steering wheel angle and hold it here. Watch a new teenager driver take a curve and they are constantly adjusting through the curve as they haven’t developed a intuit feel yet. Beyond that is the experience of noticing the left turn signal driver who doesn’t take the turn he is indicating, the non-watching pedestrian, the kids playing ball next to the road, the weather.. all inputs that the experienced driver has internalized but is oblivious for the new driving teenager.
Trading is the same way. Great discretional traders have internalized factors that are difficult if not impossible at this point in time to incorporate into mechanical systems and that new traders have not yet experienced on their own. Sentiment, news, flow, feel, pace etc.. Good discretional traders will always out perform mechanical systems until the point arrives when a computer can out-perform a good driver on the road. The one advantage that computers do have is speed, hence the rise of high frequency trading where they are able to gain a little bit of advantage. Auto technology is at the same point with computer assist (anti-lock brakes, traction control) using their speed advantage, but it still takes a human to drive. Take this as editorial.
My trading style is to use computer assist and harness the speed while using my own internal experience to actually pull the trigger. The combination of both make me a better trader. Point being, with a marginal mechanical system and a 1:4 reward stop ratio I should be able to turn a decent profit.
Hope this gives you something to think about
-Red
