In the the last post we discussed the various elements that comprise a trading system. When combined, these various elements produce a system that bears a unique signature, or personality. In order to discover whether you and this system will get along, you'll need to know more about it. Today we'll discuss some of the key questions to ask of your new found system so that you can begin to divine the likelihood of a successful future together.
One of the fundamental determinants of this personality is the expectancy of the system. Expectancy tells you how much you might expect to make per dollar risked. This is calculated across a large number of trades, and can be calculated as follows:
Expectancy = (CW * AW) - (CL * AL)
where CL is your chance of a winning trade and CL is your chance of losing on a trade. AW is your average gain on a win, and AL is your average loss on a losing trade. Those of you that are mathematicians can transform the equation, further, but this form serves the illustration nicely. If this type of thing gets you going, the I would recommend reading up on game theory, probability, and expectancy, as a solid foundation will only help to better understand system design and behavior. You can start with a few favorites here and here. (Courtesy of bjmath.com)
Next of the list of personality traits is reliability, or the chance that you will make money on a given trade. This is a figure easily produced by any of hundreds of back-testing applications.
Here's a crazy thought: You can lose 80% or more of the time and still make money! In order for this to be true, then you must keep your losses small and your wins big. Again, most back-testing applications can tell you average winner vs. average loser. This will help you to know the relative size of winners vs. losers.
What is your model for determining trade size? This is key, as many systems break down when they don't have access to large amounts of leverage, or to an unlimited source of funds.
How much do you have to trade? It's amazing to watch the difference in system performance based upon different account sizes. Think of this as "room to breathe". It is also key in overcoming transaction costs, including commission and slippage, which leads us to:
Transaction costs, or the amount it costs you to make a trade. I am a fan of BrownCo since they only charge $5 each way. Slippage should be considered as well, and you will often pay higher commissions for split-second fills. You'll need to determine whether your system is dependent on good fills. Some of the more advanced back-testing software can allow for slippage testing in a random fashion, but it would be best to avoid systems where you are cutting the margin of error this close.
Last, but not least is how often you will get the opportunity to trade, or frequency. I have a killer system on the shelf that gives an average of 30 signals a day. Since I trade end-of-day, this kind of system is not the best. A system that only generates 2 trades a year may not allow you enough chance to make money (or make money back in the event that the last two didn't go your way.) It's up to you to find a system that will generate the right amount of trades to fit your style.
You should determine the above seven variables for every system you plan to trade. The testing required to determine these numbers will ensure that you have a good feel for your ability to trade (read: to stick to) the system in question.
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