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(John Hayden doesn't sound Russian...)Good job! Well written and thorough.
I'm only a beginner but I think it breaks down into two very simple questions.
1) Does the trade/account size/risk match the reality of your account?
2) How far are you willing to train your mind?
The first you can't really escape as there are external factors already
proscribed. It's a simple math function with a single determinant, your money.
The second is as individual and unique as our lives. Relaxed, I can take twice
as many non-account threatening losses. A wild mind, I can't take one without
breaking a sweat and reaching for the aspirin. Last year, I could not take one
loss. This year I can take about three before I start swearing at the
"child-proof cap." (There's a lesson in that cap somewhere...)
On a side note, though being a lifetime member of the Religion of Math, I have
noticed that no amount of math can really make me feel better. Only I can do
that. (A little bit.)
alexander the gratuitous
John Hayden wrote: part 2 continues---------------------Once we know the
amount of heat we can endure we must decide on how we will measure the
performance of the trading logic. Below is a list of the common, and not so
common indicators. However, what determines what a "good" value is for these
indicators will depend largely upon the traders answers to the above questions.
Here is a summary list. The minimum performance levels are based on trading a 1
lot S&P on a 3 minute chart, and doesn't account for slippage or commissions
(as this seems to be the standard practice):1. Net Profit per Trade (Avg. $ per
Trade) $ 200 minimum2. Profit Factor (Gross Profit/Gross Loss) 2.0 minimum3.
Drawdown/Run-Up Analysis4. Sharpe Ratio 4.0 minimum5. Total Trades 2-6/day
max6. Total number of Longs/Shorts Ratio ~1:17. Total Net Profit n.a. -
subjective8. Average Winning Trade9. Average Losing Trade10. Average Win To
Average Loss Ratio Depends on % winners11. Largest Loosing Trade/Average Win
Ratio 1.5 or lower12. Largest Drawdown/Average Win Ratio 7.0 maximum13. Average
Drawdown/Average Win 1.0 Maximum14. Percent of Winning Trades n.a. -
subjective15. Max. Consecutive Winning, & Loosing Trades n.a.16. Average Number
of Winning, and Loosing TradesGross Profit per Trade (GPT)Calculation: Total
Profits divided by Total TradesThis number is perhaps the most important
because it tells us the average profit we can expect to make on each trade.
Each trade will generate two associated cost; slippage, and commissions. Should
the GPT be low then slippage will change a profitable system to a loser. The
higher this number the better. It is important to realize that when commissions
AND Slippage are factored in many systems fall apart because this number is not
higher than actual cost. Generally this number should be twice the expected
amount of slippage - plus the commissions cost - for the S&P $200.Profit
FactorCalculation: Total Profits divided by Total LossThis number will tell us
the amount of profit we gain for every dollar placed at risk. Generally we want
to risk $1 for the possibility to gain at least $2 dollars.Drawdown Analysis -
Consecutive Losing Periods1. Determine the percentage of money lost (maximum)2.
Identify the length that it took to hit this maximum percentage loss.3.
Identify how long it took for the Recovery to take place.4. The Peak is the
time frame just before the drawdown began, or the Start Date (which is one time
frame less).5. The Valley is the time frame that the worst percentage loss was
experienced.6. Identify the maximum amount of money lost.7. If not using time
to identify length of drawdown then determine the number of trades before the
equity is restored.Run-Up Analysis - Consecutive Winning Periods1. Determine
the maximum percentage of money made in the Run-up.2. Identify the Start date
the winning streak began.3. Identify the End date of the winning streak.4.
Identify the length of time that it took to hit this maximum percentage gain.5.
Identify the maximum amount of money gained.6. If not using time to identify
length of run-up then determine the number of trades before the equity is
begins to decrease.Generally we want to avoid any systems that experience more
than a 30% loss of capital. We must totally avoid systems that generate 50% or
more of a drawdown as it becomes almost impossible to recover from such a large
reduction in ones equity. In judging the length of a drawdown to endure it is
generally best to look for a system where the total length of the longest
drawdown is no more that twice as long as the total length of the largest
run-up. This is a subjective rule and is totally dependent upon the trader and
the amount of pain he can take.Sharpe RatioThe ratio is based upon comparing
the standard deviation of the system returns and the amount of risk of that
system - to the amount of return that could have been earned in a risk free
investment. Generally the higher the Sharpe Ratio the better the system. The
Sharpe Ratio is a good way to compare different strategies as it levels the
playing field. Again this is a subjective evaluation however generally I would
like to see a value of 4 or higher.Total TradesThe concept is simple; can the
trader actually trade the system? How many trades a day (or whatever unit of
time the trader wants to use) is the trader comfortable with? How easy is it to
execute the trades? Is the execution method reliable? Generally I like 4-6
trades per day, however this is dependent upon the trader.Total Gross
ProfitCalculation: Total Profit less Total LossThis number is totally dependent
upon the trader. Largely depends upon if the trader is trading full or part
time. Must he trade to pay the bills? If so, then the total net profit required
will be dependent upon the traders' lifestyle. This doesn't include commissions
or slippage.Average Winning TradeCalculation: Total Gross Profit divided by
total winning trades.This number tells us the average amount of profits per
winning trade.Average Loosing TradeCalculation: Total Gross Loss divided by
total loosing trades.This number tells us the average amount of loss per
loosing tradeAverage Win To Average Loss RatioCalculation: (Total Profits
divided total number of winning trades) divided by (Total Loss divided by total
number of losing trades).This ratio is based upon the average gain of winning
trades, and the average loss on the loosing trades. While it seems similar to
the NPT or Profit Factor it is not. This is because the other primary variable
is the percentage of winning trades. With this ratio we can have a profitable
winning system that will generate larger loosing trades than winning trades.
The reason this is profitable is because the percentage of winning trades is
more than 50%. Generally I want to see at least 2.5 or more - 250% more average
gain than loss.Largest Loosing Trade/Average Win RatioCalculation: Largest Loss
divided by Average Profit per winning trade.This ratio will indicate
approximately how many winning trades it will take to recover from the largest
losing trade. Generally a value of 4 or less is good, I prefer 1.5 or better.
As this is telling us that with 4 (or 1.5) average winning trades we will
recover from the largest historical loss. Again this relates to the amount of
pain a trader can endure.Largest Drawdown/Average Win RatioCalculation:
Determine amount money lost in the largest Drawdown divided by the Average
Profit per winning trade.This ratio will also give us an indication of the
amount of pain that must be endured. We will know the approximate number of
winning trades it will take to recover from the largest historical drawdown.
When combined with percentage of winning trades we can then begin to estimate
how many trades overall must be traded. Generally I do not want to see a ratio
above 7.0. In other words this is telling me that in 7 winning trades I should
recover from my drawdown.Average Drawdown/Average Win RatioCalculation:
Determine the average amount money lost in the all of the Drawdown's divided by
the Average Profit per winning trade.Similar to the previous ratio we will know
the approximate number of winning trades it will take to recover our lost
equity. When combined with percentage of winning trades we can then begin to
estimate how many trades overall must be traded. Generally I want the value to
be no higher than 1.0.Percent ProfitableCalculation: Total number of trades
divided by total number of winning trades.This ratio relates to the number you
times you can make a losing trade without getting upset or doubting the
integrity of trading logic. In my opinion it is the least important of the
ratios in determining the overall profitability of a trading system. Generally
I would like to see 50% or more - however it really doesn't matter all that
much to me. The percentage of winners is totally dependent upon the traders'
psychological makeup.Maximum Number of Consecutive Winning and Loosing
TradesCalculation: Determine the maximum number of consecutive winning and
loosing trades.Average of Maximum Number of Consecutive Winning and Loosing
TradesCalculation: Average the maximum number of consecutive winning trades.
Average the maximum number of consecutive loosing trades.These two numbers will
begin to tell us what we could expect in actual trading and will be one of the
first indications that the trading logic has gone astray when trading in real
time. They are also totally dependent upon the psychological makeup of the
trader.A word of warning.The challenge of creating a trading system for an
experienced trader is that he is attempting to create a mechanical version of
himself. Computers are incredibly dumb machines and cannot change their
"programming" on the fly. They are very systematic and they are not
discretionary. This is their weakness and their strength. Most experienced
traders are to a certain degree discretionary in their day-to-day execution of
trades.Because computers are very systematic they will always execute the code
in the same manner with the same results provided the inputs are the same.
Should the inputs change then the output will change. The goal of every trading
program is to execute the same buy regardless of when the data stream was
started. In other words if we are using 3-minute historical data that starts on
4/1/01 and ends on 4/1/02, and our logic only needs 30 days of 3-minute data.
If our system generates a buy on 10/1/01 1:30pm, and then exits the trade at
10/1/01 2:15pm our goal is for the buy to be generated for 10/1/02 1:30pm
regardless if the data stream being used starts on 4/1/01, or 8/1/01.All too
often this is not case, the date and time the data stream begins will prevent
the trade on 10/1/01 at 1:30 from being triggered. The goal is that the trade
consistently be triggered.Another problem is that using historical data to
create a trading system will in actuality create a system that has been "curve
fitted" to some extent - regardless if optimization studies were performed on
the variables. This is because the system creator has the vision of 20-20
hindsight. Curve fitting becomes apparent data from a different time period is
used.This is why the adage you read everywhere "past performance is not
indicative of future performance" - because it is the truth. This is true of a
computer based trading system or an individual trader!
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