Las Vegas. Great food, show girls, and a
multi-billion dollar gambling business. The money made by the casinos is
only matched by the profits on Wall Street. And the profits of both are
based on mathematical probabilities.
Casinos make money because “the odds” or
a game’s expectancy are in the house‘s favor. This means that if you play
long enough, the casino wins. Over the short term, the casino knows it may
win or lose. But if you play long enough, the house always wins. The
casinos increase their profits by offering games that are completed in a
short period of time – a roll of dice, a spin of a wheel or a few cards
turned over.
What does this have to do with trading
systems?
We want the odds of a trade to favor
us – expectancy
We want a lot of trades – opportunity
We want turn over so we can compound
the profits – holding time.
What we as traders must do is become the
house. The odds in our trading must favor us, we need a reasonable number
of trades during the year and the trades must be completed in a reasonable
amount of time for compounding to be effective.
Expectancy is simply the product of your
profit percentage per win and your win rate minus the product of your loss
percentage per loss and your loss rate. For example:
Win percentage
6%
Win rate
60%
Loss percentage 4%
Loss
rate 40%.
The expectancy is 2.0% per trade, or (6%
x 60%) - (4% x 40%).
That means, on an average trade, 2% of
the money traded is yours to keep. That’s better odds than a casino gets
on blackjack. Now, that may not sound like a lot of money. If your average
trade is $10,000 – 2% is $200 profit per trade. If you have 300 trades per
year, then you have a $60,000 profit per year with an average trade of
only $10,000. This does not even include the profits if you compounded the
average trade.
If you explore the expectancy formula,
you will notice that there is no one set of numbers that could give a
positive expectancy but an infinite number of sets and therefore an
infinite number of trading systems that could be profitable.
Given that, it is possible to develop
systems where the stop loss is larger than the profits. The stop loss is
academic, as long as your profit expectancy is positive.
Here’s another example: we could use a
20% stop loss and a 5% profit target and come out with the same exact 2%
expectancy as long as my win rate is high enough! An 88% win rate in this
example would yield 2.0%, the result of (5% x 88%) - (20% x 12%).
Or, you could arrive at a positive
expectancy with a very low win rate. One of the more famous expectancy
numbers comes from William O’Neil, advocate of the CANSLIM system and
founder of Investors Business Daily. If we use his stop and target numbers
of 8% and 20% and his published win rate of 30%, the expectancy can be
calculated to be: (20% x 30%) - (8% x 70%) or +0.4%.
The bottom line is: expectancy must be
positive if you want to make a profit over time. Never use a system with a
zero or negative expectancy. You will not win. You can not beat the house
over a long series of bets or trades. Be the “House”.
No matter what your expectancy is, you
will not make a great deal of money unless you have a lot of opportunities
to trade. Again, the casino analogy. The casino may only make 1-2% per
hand of blackjack, but they turn over those hands very quickly – 30 to 40
hands per hour. Play blackjack long enough and you will lose over 40% of
your money per hour! No wonder they can offer those wonderful comps.
We now know how to create a method, at
least on paper, with a positive expectancy. Let’s say we develop a system
with 8% expectancy, but if the system only yielded one trade per year,
what good would it be? We might as well just put the money in a savings
account. Or, if we had a method that yielded 0.2% per trade, you might
pass on it? But what if that system generated 1,000 trades per year? 1,000
times 0.2% becomes serious money in a very short time.
The most overlooked area of trading is
the "holding period." In order to make money, you must have a system that
generates a positive expectancy and a lot of opportunities. But you must
have access to your money. If your trade’s hold time is too long, you
can't take advantage of all or even most of your opportunities. Your
trading money or buying power is always tied up because you have to wait
too long to close your trades.
Casino analogy time. If the house odds in
Blackjack are 2.5%, that means for ever $2 bet, the casino makes, on
average, 5 cents. If you only play 1 game per hour, the casino makes 5
cents per hour. If you play 60 games per hour, the casino has all of your
$2 in 40 minutes. All things being equal, the game with the fastest
turnover is the more profitable for the casino.
It's no different with trading. You will
be more profitable with $100,000 that you could "turn" 250 times per year,
than $500,000 that was tied up in one trade for 12 months. As an example,
let's say we have one trade and that trade yielded a 50% return. You just
had a great year - a $250,000 profit.
On the other hand, say you had $100,000
for stock purchases, and your expectancy was only 1.2% per trade but you
turned over your stocks 250 times in the same year. This method ends up
generating $300,000 for the year, and that assumes you never increase the
position size as the equity grows. You just had a better year. And it is
easier to get 1.2% per trade than 50%.
