Friday, June 27, 2014

Expectancy is not the only consideration

When looking to develop a trading method, calculating the projected expectancy is a major part of evaluating whether an idea is worth pursuing.

However, it is not the only factor that needs to be considered - you also should look at trading opportunity. As an example, take the following three systems:

System A generates an average of 5 trades per month over a year, with a positive expectancy of +1R per trade.

System B generates an average of 10 trades per month over the same year, but with a positive expectancy of only +0.7R per trade.

System C generates only 2 trades per month, with a positive expectancy of 2R per trade.

Which one would you choose?

All things being equal, System A would generate returns of +60R over a year, System B would be +84R, and System C would be +48R.

So, while System B has a lowest expectancy per trade, it has the highest level of trading opportunity, and consequently the potential for the highest overall returns. System C, which had the highest expectancy, would end up yielding the lowest annual return, as it had the lowest trading opportunity.

Some further considerations to this:
  • more trades means more transaction costs;
  • more trades generally means a shorter-term timeframe and preferred holding period;
  • the shorter-term the timeframe, the higher the probability of being subject to market 'noise' or whipsawing;
  • the longer-term the system, you would get your entry and exit signals later than someone trading the same stock or instrument on a shorter-term system;
  • more trades may mean the potential for more trading mistakes;
  • the potential for acting upon the entry and exit signals may be dependent on your access to your trading platform (work and family commitments), so if you are limited in any way that may automatically move you towards a longer term system, with fewer trading opportunities.
One way around having a high expectancy figure, but a low trading opportunity, would be to see if your method can be utilised on different markets.  Providing the same level of expectancy can be achieved on any new markets or instruments, then this can be an easy way to multiply your potential returns. For example, if you trade stocks, would it also work on commodities, or foreign exchange, or stocks in different countries?  This could also provide you with some diversification across different asset classes or geographical locations. You would need to research this further to see if this would be the case.

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