Friday, April 18, 2014

A question for you

Take two trading systems. Both have the same positive expectancy measurement.

System A has a low win rate, but the size of its winners far outstrips the size of its losses.

System B has a very high win rate, but its winners are smaller than the size of its losses.

Which system would you choose? And why?

Most new or inexperienced traders will seek comfort in System B - the fact that you have a high win percentage (even if they are only small winners) seems to seduce people. They would rather be proven right about a trade, rather than be focused on risks, rewards, and money.

You quite often see automated forex systems that are like system B. "Look - 95% win rate!" the advert says. What they don't tell you is that, to achieve these small winners, they have very large stops, which are much wider than any price target.

People can be lured in by these kinds of systems, and if they are not careful, risk too much per trade. What happens when a trade goes against them? They may only be looking for 10 pips of profit, but they may have a 100 pip stop. What if it reached that level - do they think "it will come back", and let the loss run?

A trend following system would look something like System A. Certainly, you won't see many systems being promoted saying "Look - 35% win rate!". But that is the reality. These traders lose more than they win, but they factor that into their trading plan. Stops are kept tight, and losses are contained. However, there are no restrictions or price targets used. Profits are left to run, some of which can end up being many multiples of what was originally risked.

The danger is that someone trading System B could fall into the trap of thinking they've found the holy grail - a system which just churns out profit after profit. Risk control is low down on their priorities (if it is considered at all).

There is also the psychological factor to consider. Say you had a run of 20 consecutive winners with System B. Yet, on trade 21, you make a huge loss which wipes out of those small profits, and possibly worse. How would you feel?

What do you think happens if both systems suffer a run of losing trades - worse than the average? This can and does happen, to all systems. It may be as a result of a change in market conditions, or possibly a change within the trader themselves. You need to factor to that into your risk plan.

Whatever your worst run of losses (and drawdown) is, I'd at least double it when creating your system and risk parameters. If your not comfortable with what those circumstances would bring, then reduce your risk per trade.

Take the example System B figures above - the stop loss is 10 times greater than the profit target. You wouldn't need too many of those trades in a cluster to severely damage your equity, even using a small equity percentage per trade (yes, there are systems out there like that!)

These two systems can bring out the best and worst of people's approach to risk. Someone using system A will know he could have a run of losing trades, and takes that into accounts when setting his risk parameters. Speaking to others who have traded variants of System B, because of the logic behind those systems, there is an inherent danger of a very quick significant draw down or even a blow up, especially if their risk management is weak.

To conclude then, it is my belief that those traders with low win percentages, but an overall positive expectancy, end up being better disciplined at controlling their risk.

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