From the April 2013 issue of Futures Magazine • Subscribe!

Avoiding trading paralysis by analysis

Intangibles

While by themselves these trading statistics don’t provide a complete picture of a trading system’s value, traders can’t ignore the psychological benefit they may offer. We are, after all, conditioned since grade school to evaluate ourselves in terms of winning percentage. Everyone wanted to score a 95% and bring home an “A,” after all. And who didn’t want to hit a game-winning home run in playground baseball?

If you are one of these traders, then having a low winning percentage might be impossible to stomach, and never banking a big win might be unfulfilling. The risk here is an unfulfilled trader might become an undisciplined trader. Although you shouldn’t let emotions affect your trading, not recognizing your personal tolerance for financial risk would ignore reality.

To that end, if you have an idea of your desired winning percentage, the equation presented earlier can be arranged to tell you the minimum reward-to-risk needed. 

For positive expectancy, R:R > [(100 – win%) / 100] / (win % / 100) 

In the same manner, the equation can be rearranged to return the necessary winning percentage for a given reward-to-risk ratio:

For positive expectancy, win % > 100 / (R:R +1)

Using these two modified equations, it is easy to determine the minimum requirements for profitability. This is shown in “Rewarding relationships” (below). Any strategies above the line will be profitable, while those below the line will be losers and should be avoided.

Using the concepts presented thus far, it is easy to evaluate real-world trading strategies. The table below presents four futures trading strategies. All have some appealing aspects, whether it is high winning percentage or a high reward-to-risk ratio:

System Win % R:R
1 25.3% 3.8
2 43.7% 2.9
3 44.7% 1.5
4 54.6% 0.5

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