Traders should be concerned about making money; after all it is the reason to be in the markets. In the beginning, most traders are concerned more about the total return of their investment rather than their exposure. However, stay in the game long enough and you will agree with the professionals - take care of the losers and the winners will take care of themselves.
When reviewing a trading system you should concern yourself with the breakeven level of your system. Or the minimum level of performance that will still show a profit. In plain language, "how often can you be wrong and still make money?"
Let's look at two different trading systems and see how they compare:
System #1
Percent Accurate: 65%
Average Win: $850
Average Loss: $1,100
System #2
Percent Accurate: 37%
Average Win: $3,400
Average Loss: $900
On the surface system one looks substantially better than system two. It is 65% accurate after all. Most traders can stomach being right 6 times in 10. System two with its 37% accurate would be hard to sit through - or so it seems.
When you look at expectation per trade you begin to see the big differences between the two systems. The expectation per trade measures the expected amount you will make on a given trade. This statistic uses a sample of the trades from a given track record.
System One expectation per trade: $167.50
System Two expectation per trade: $691.00
System one has a low expectation per trade. A little bit of slippage or transaction costs can eat of the majority of its expected profit. System two has a more robust expectation. Slippage and transaction costs will not decrease its expected profit as much as system one.
Looking at the breakeven percent shows an even bigger difference in the two systems:
System one breakeven percent: 56.4%
System two breakeven percent: 20.9%
System one must be right more than half of the time just to generate profits while system two can be right less than 25% of the time. With this information, which system would you rather trade?
Assume you begin trading each system, each takes 10 trades. Both systems loose the first 8 trades and the last two trades are profitable.
System One After 8 losers: (8 x $1,100) = ($8,800)
System Two After 8 losers: (8 x $900) = ($7,200)
System One Next 2 trades are winners: (2 x $850) = +$1,700
System Two Next 2 trades are winners: (2 x $3,400) = +$6,800
System One Net results of 10 trades: ($7,100)
System One Net results of 10 trades: ($400.00)
What happens if you begin trading either system and you hit a string of 8 losers? System one is down $8,800 and system two is down $7,200. What happens if the next two trades are winners? System one will be sitting at loss of $7,100 and system two will be at a loss of $400.00. The recovery time of system two is much better than the recovery time of system one.
Manage your breakeven percent and making money is easier. Do not be fooled into trading a particular trading system just because of a so-called high percent accuracy. At the end of the day, your gut will measure drawdown recovery and your mind will accept a lower accuracy.
