Between Running A Business And Systems Trading
By Trading Secrets
Treating your systems trading as a business
Let me again draw some parallels between running a business and systems
trading. Most successful businesses keep statistics on everything from
their systems trading to their average dollar sale to the amount of people
that come in the door. The reason a successful business does this is because
they understand you must first keep score before you can begin to improve
on that score. Systems trading is exactly the same.
Now that youre looking to trade as a business, you need to learn some
valuable statistics about your system so you can improve its systems trading performance. How could you ever expect to improve your systems trading
unless you knew what it was you were looking to improve? Let me now cover
a few of the definitions and major statistics that you need to know about
your system. Firstly, you must understand the principle of R multiples.
R stands for risk, the risk you take on any trade when we enter the market.
The R multiple of a trade is the ratio of the profit and loss compared
to the amount of money risked to make the profit or loss.
Hence, if you risk 200 dollars from systems trading in your initial stock,
and you make a profit of 1,000 dollars, then you have made five times
the amount you risked in the trade. In other words, you have an R multiple
of five. Ultimately, youre just wanting to get a good idea of your relative
size of profits to your losses from systems trading by simply taking our
average size of our winning trade and comparing them with the average
size of our losing trades.
Next you want to calculate your win to loss ratio. That is how many times
you get a winning trade to how many times you get a losing trade during
the course of your systems trading. For example, if you had ten trades
and four of those trades were winners, and six were losers, your win to
loss ratio is simply four to six. This is just your hit rate from systems
trading. In other words, you get 40 percent of your trades correct.
Can you believe that these simple two statistics that Ive now gone over,
you can calculate the average size of your winnings and the average size
of your losers, multiply these figures with our win to loss ratio, and
youll be able to calculate on average how much money you make with every
dollar you risk from systems trading?
Another vital systems trading statistic you need to know about is your
draw down. What is the maximum historical draw down that your system has
received? What youll tend to find is systems that have a very high rate
of return will also have massive draw downs. Is that draw down is something
that you can live with?
Im starting to introduce a few high level concepts to whet your systems
trading appetite and encourage you to read more about back testing a system.
To go into these in detail is a little bit outside the scope of this article,
however, if you want to take your systems trading back testing knowledge
to the next step, I recommend you get a fantastic book called Trade Your
Way to Financial Freedom written by Dr. Van Tharp. He goes into these
and many more concepts in much more detail. For those of you who think
this sounds like a little bit too much work, let me put forward a scenario
that will illustrate the importance of back testing your system.
Imagine systems trading a system that you knew had a wins and loss ratio
of 60/40. You made profit on every six trades and lost on every four.
How do you think you would feel and where would your confidence level
be if after you traded the system for a little while, you had received
a string of 11 losses in a row? Now, you knew that this system had a win
to loss ratio of six to four. Would you have the confidence to open another
trade if your systems trading is brought up another buy signal after getting
11 trades wrong?
Unless youve back tested your system, I would highly doubt it. That systems
trading may have been a fantastically profitable system, however, since
you hadnt back tested it, you didnt know that historically, this systems
trading had received up to 13 losses in a row, and even with 13 losses
in a row it was still a profitable system, but, of course you wouldnt
know that unless you back tested the system.
Heres another point you may not have picked up unless you have done the
correct back testing. Once youve employed excellent money management
and you begin systems trading, be ready to experience a string of losses
as soon as you begin. Countless times Ive had clients who get disheartened
by this fact because they dont understand the nature of setting good
management. If were adhering to the rules of cutting our losses short
and letting our profits run, obviously because were cutting our losses
short, those trades are going to last for a shorter amount of time.
This means once you begin systems trading, the odds of getting losses
early in the race, are much higher than getting a winning trade especially
when you consider many successful systems tradings run on a 40/60 win
to loss ratio. The point Im trying to illustrate here is you will not
know the intricacies of your systems trading unless you back test it.
You need to begin to get an understanding of what works and what doesnt
from your own particular systems trading. You shouldnt believe everything
Ive told you. Instead, you need to prove it to yourself and this is done
through back testing of your systems trading.
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