If you find yourself testing and testing in the hope of stumbling across that magic secret that will unlock the market and all its profits. Remember, you will never create a trading system which has a 100% success rate. Many have tried and many have failed.
You should be looking for a good trading system with minimal draw-down and a good reward risk ratio. Many trading systems have more losing trades than they do winning and yet they still makes money. How? Well, as you learnt in Trading Secrets Revealed, the holy grail of trading is your Money Management
Analyzing Trading Systems
The astute system tester may have realized that a slight change in a trading system’s variables can have dramatic effects on its profitability. But is profitability the only criteria by which you should be evaluating a trading system?
Clearly the answer is NO!
Here are just a few other criteria you need to look at:
- Are you satisfied that your system is reliably profitable?
- Will your draw downs wipe out your account?
- Is your system trading in a way you can tolerate?
- Can you tolerate long periods of no trading or too
- Can you tolerate a large string of losses?
To fully answer these, and other similar questions, you must analyze the results from your back testing. Unfortunately, with the plethora of trading statistics that most back testing programs provide, this can easier said than done. I believe you really only need to pay attention to a few critical statistics. Here are the ones I pay close attention to:
Win/Loss Ratio
When you assess the performance of a trading system, one of the first statistics that gives you a good indication of the strength of that system is the Win/Loss ratio. Quite simply, this is the ratio of the average winning trade in dollar terms, against the average losing trade in dollar terms.
If this ratio indicates you are, on average, winning more than you are losing, you are on the right track. However, realize that this statistic on its own isn’t enough because it doesn’t consult how
Risk Multiple
The risk multiple (R-Multiple) builds upon the win/loss ratio in that this is the win/loss ratio compared to the amount of money risked to make that win/loss.
It's a measure of the reward obtained from the trade compared to the amount of risk taken for the trade.
For example, if you risk $100 and make a profit of $500, then you have made 5 times the amount you risked in the trade, in which case, you have an R-mulitple of 5. This means that for every $1 you risked you were rewarded with $5.
Similar to the win/loss ratio, this statistic on its own isn’t enough to determine whether a trading system is worth trading.
Expectancy
A trading system’s expectancy is perhaps one of the most powerful statistics you can have because it is a way of quantifying the performance of a system that is independent of the size of the trading float.
Simply it answers the question how
In short, it returns the expected dollar return for each dollar risked by the trading system. This is different to the reward risk ratio which we described above, that was a specific ratio of reward to risk. Expectancy defines a return in dollar terms for every dollar that you risk.
For example, a system with positive expectancy is one in which a positive dollar return is expected for each dollar risked. If your system has an expectancy of +0.75, on average you would expect to make .075 times the amount you risked in the trade. If you risk $1, then you would expect to make on average $0.75 for every trade you take.
As a guide, if you can achieve expectancy of $0.60, you have a good profitable trading system.
Number of Trades
Then there’s, the number of trades a system gives over the course of a year. I find this an invaluable, yet rarely talked about, statistic.
Your trading system should not give too many or too few trades. The number of trades that a trading system gives should be approximately the same as what can realistically be taken.
The two sides of the coin are equally dangerous. If a system gives too many trades, you will be forced to choose between signals, therefore adding ambiguity to the system. With ambiguity comes human discretion and this often has a detrimental effect on the performance of the trading system.
On the other hand, if a system gives too few trades, your trading capital will not be fully utilized and you may not be taking full advantage of the available trading opportunities.
So how do you calculate the optimal number of trades for a trading system? I’m glad you asked ? :)
This is done with the calculation called “opportunity.” In short, opportunity helps determine your optimal opportunity for a trading system.
Opportunity = (240 / Average Days In Trade) * (Trading Float / Average Trade Size)
For example the optimal opportunity for a trading system with the following variables would be:
Float = $25,000
Average Days In Trade = 19
Average Trade Size = $3,500
Annual Profitability Return
Lastly, with the statistics we’ve now covered, we can calculate the annual profitability return of your trading system. The profitability of a trading system is the combination of the expectancy and opportunity.
Now, it’s simply a matter of plugging in the values you have already calculated into the formula below:
Annual Profitability Return = Expectancy *
For example, if a system with an expectancy of .75 had an opportunity of 72 trades per year and we risked a maximum of 2% per trade, the annual profitability return would be calculated as follows:
Annual Profitability Return = .60 * 72 *2% = 86.4% p.a.
Can you see the power within these statistics? Statistics really is a topic worthy of a complete course itself. They really do provide tremendous insight into a trading system.
If you found this topic interesting and would like to further expand your understanding of this topic. You may be interested in looking further into Dr. Van Tharps work. In fact, he has a fantastic course that covers these topics, and many others, critical to the understanding of system design.
Tharp’s course is called Developing a Winning Trading/Investing System That Fits You, and I have found it invaluable. Although it’s not critical, you can purchase your copy online by clicking here.
Let’s make you a market wizard.
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