Saturday, August 02, 2014

The magic formula to trading success

It has been often said that trading is simple, but not easy. Quite often you can find a big discrepancy between what your anticipated returns are, and what you actually achieve when real money and emotions are on the line. 

You may know other people who trade the same method, but get far better returns than you. To help maximise your performance, as part of your review process try using the following formula:

Positive expectancy x Trading opportunity x Trading efficiency

Let's look at these elements in more detail:

Positive expectancy - this is the figure you can calculate where you work out, on average, what your profit (or loss) for each trade taken. A positive figure indicates that you could make money, a negative figure indicates you will lose money. Ideally you want the positive figure to be as high as possible. More on expectancy here.

One important caveat here - to be able to rely on your expectancy figure, you need to have traded your method across a large sample of trades, across differing market conditions.

Trading opportunity - how often you receive actionable signals using your chosen method? In general terms, the higher the number of opportunities, the better. It is possible for one method to have a lower level of positive expectancy than another method, yet achieve bigger returns if it gives more signals to trade. See more on this here, with some examples.

The key word is actionable. If you have a full-time job, and you are trying to day-trade, then your number of actionable signals will be very low. Chances are you will also miss the best times to day-trade in each session.

The caveat here is that, while you wants lots of opportunities, you need to ensure that you do not exceed any overall risk parameters that you have set yourself.

Trading efficiency - how accurately you are able to follow the entry and exit signals you receive? How accurately do you follow your risk management, and generally avoid making any trading mistakes? It is possible for a trader to turn a winning method into a losing one by simply not being able to follow their rules, or significantly reduce their profitability. Every error or mistakes lowers your efficiency. Again, this can be quantified over time in terms of R.

The biggest errors I come across is people taking too many signals, and/or taking on too much portfolio heat. I have specific rules governing the number of trades I can take on a given day, or have open in total. These limits are based on the general market conditions being favourable towards my own style, and will be lower when the conditions are against me. If I exceed these limits, that to me is a mistake (even if I end up making a profit on that mistake!) . More on trading efficiency here.

Putting it all together
Lets use a simple example to see how this works. Suppose you have a system that generates 100 trades per year, with a positive expectancy per trade of 0.5R. In theory then, your method should be able to generate profits of 50R in a year. If you risk 2% of your equity per trade (and ignoring the compounding element), you should be able to make 100% per year. Nice.

Now, suppose you have made 20 errors in the year - in other words, on 1 in every 5 trades taken you made a mistake. By tracking these errors, you quantify that these mistakes cost you a total of 25R (an average of 1.25R per trade).

Then take the total mistakes (25R) and divide by the expected returns (50R). This gives you a trading efficiency of only 50% (25/50)!

Okay, in this example, you may still make 50% in the year, which is not to be sniffed at, but think about all those profits you left on the table. Those errors have lost you half of your expected returns!

I've seen examples where people make very few mistakes over the course of the year, but those mistakes are very big in terms of R - an example may be ignoring an exit signal on just one trade, and the stock price subsequently cratered, causing a huge loss. That has the same effect.

Do this over a bigger sample of trades, over a number of years, and you can quickly see how, with the compounding effect, this has a huge impact on what you could achieve.

Some points to take away from this:
  • Note I didn't say anything about how you should trade in terms of entries or exits. While my own preference is to follow trends, there are plenty of ways to make money from the markets, all on different timeframes. If your method has a positive expectancy, and gives frequent enough signals, then you have the basis from which to make money.
  • You can take a method with relatively low expectancy and opportunity, trade it with high efficiency, and you can make money. Conversely, you can take a method with high levels of expectancy and opportunity, trade it with low efficiency, and you can lose money.
  • Therefore, the ultimate determinant on whether you can make money is YOU. Can you follow the signals? Can you avoid the mistakes? Can you control your risk? In other words, can you trade with a high level of trading efficiency?
  • In order to quantify all this, you have to keep a proper record of all your trades. Be as objective as possible. This needs to be a 'warts and all' review, being critical of your own performance. If you sugar coat things at this stage, then you will never achieve your ultimate performance.
  • Then, once you have done your review, you need to formulate the changes needed in your approach to achieve a higher level of efficiency. Update your trading plan with the necessary changes. And, most importantly, act upon those changes!
  • Looking at the above example, it should be clear how an improvement in your trading efficiency can transform your performance. Instead of continually chopping and changing your entries or exit rules, or developing some new indicator, focus on eliminating those errors - focus on YOU.

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