From the October 01, 2010 issue of Futures Magazine • Subscribe!

Trading’s Holy Grail: Your calculator?

Opportunity profit

Another trading math variable that is often ignored and grossly misused is opportunity factor or frequency. How often a particular setup occurs is only one variable and cannot be used in isolation. Most new traders associate more trading with more money. That may or may not be a true statement.

Which system would you rather trade (net of commissions and slippage)?

A) $50 expectancy per trade.

B) $20 expectancy per trade.

Another no brainer. Answer “A” makes more money due to its higher expectancy. But what if you had more information? For example:

A) $50 expectancy per trade and four trades per month ($200).

B) $20 expectancy per trade and 20 trades per month ($400).

In this particular example, the higher frequency trading does yield more profits, but that is not always the case. The true answer lies in the combination of expectancy and frequency.

These simple exercises clearly illustrate that you must have the proper data to formulate a true analysis of any trading setup or methodology. The one takeaway should be to never commit to any trading methodology without knowing (or at least having a clear idea of) its win rate, win/loss ratio and trade frequency. The search for the Holy Grail may end with the calculator located in the top drawer of your trading desk.

Trading systems can be built to try and produce a high win percentage or to ensure winning trades are much larger than losers, the old “cut your losers short and let your winners ride” theory. Typically, long-term trend following systems produce more losers than winners, but the winning trades are much larger than the losers. Shorter-term systems that trade more often usually look to produce a higher win rate, though there are exceptions (see "Different ways to skin a cat," below).

Our last example included the qualifier “net of commissions and slippage.” But commissions and slippage must always be included in your analysis. More trading equals more commissions and more possibilities for slippage. Some markets are less liquid than others and will produce more slippage, which must also be factored in when deciding on how to trade it.

If you are considering a new trading setup or methodology, make certain you have access to all of the data required to properly analyze the new approach. If you cannot get the answers you require, then keep your money safely under your mattress until you have forward tested sufficiently to gather representative figures. Without the proper mathematical data, how do you know if the new approach actually makes money? And, if you don’t know if it makes money, why would you ever risk your capital? These are tough questions, but they absolutely must be answered.

To be a successful trader, it really comes down to a simple formula: understanding the math + a robust trading plan + discipline = trading success.

Spend your time studying more data and fewer charts and the odds are your journey to success will be greatly expedited.

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Tim Mock trades for his individual account and is a trading coach with Master the Gap Inc. You can reach him at tim@masterthegap.com.

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