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A Time Traveler and a Trade

  #14 (permalink)

North Carolina
Trading Experience: Beginner
Platform: NinjaTrader, Tradestation
Favorite Futures: es
Posts: 644 since Nov 2011

@lax99 I am assuming you are referring to taking several small losses vs one large loss. I will try to elucidate some of the important themes that are relevant for this topic. The first theme is this idea of a relationship between gross profit and net profit. Normally if you have an edge then if you take more mediocre trades, that is trades with a lower profit factor, you will have the potential to increase the gross profit and subsequently the net profit constrained by your trading costs. But, your quality of trade will decrease. So, you have this relationship where you have the potential to make more money but any given trade is a lower quality.

On the other hand, you can decrease your trading frequency thereby increasing your quality of trade. The downside is you have fewer samples to work with and thus you need to take more risk on any given trade. So, there is a relationship actually where you can actually lose more money taking better trades then worse trades. Take it to the extreme, take a system that has an edge and let's imagine you take the very best trade in any given year that the system produces but yes you are taking the best trade but you're not taking enough trades to profit at statistical confidence. Something that is worth understanding is that if you have a 55% probability of making more then losing on a trade for a given event then your probability of making money if you trade 100 events is way higher then if you take one event. This is really basic but it is important to understand. That's why a casino can make money because even though the edge is small if you multiply that and limit the risk then the certainty of making money becomes very high. In order to take advantage of a small edge, you need to strictly the limit the risk and you need a lot of events.

Obviously, everyone would like to be the casino but the reality is that is difficult to do. So, if you are taking the view of the outsider then you may prefer to take the view of trading larger and less frequently because it decreases any relative disadvantage you might have.

We can look at this from another perspective. So, obviously if we know a trade is a higher probability of losing and we can scratch, that is break even, on that trade then it is obviously better to do that. The problem with that notion is that below a certain threshold a human or discretionary trader simply cannot compete. Yes, it is sometimes but that can easily become illusionary. Beyond that, even if it were possible, it is not clear that you could use this to your advantage if you were trying to trade a larger trade. So, this has do with the fundamental wavelength and periodicity of information. Let's imagine your fundamental information you are trading on, your edge, is hourly bars. If we imagine the range on that bar is 10 points and 60 minutes. Right, if you're trying to act on that wavelength on information with only say 1 minute or 1 point, you're acting on basically 1% of the information relevant to your frequency. So, there are multiple constraints that limit ones ability to control or limit risk and those limits are (1) Your ability to react, (2) The frequency of your edge, and (3) Your trading costs. Because other trades may have "vertical edge" then the trading costs is important beyond (1) and (2) and act as additional constraints.

The final consideration is the probability of a sustained movement and the degree of horizontal versus vertical movement in the market. So, stop losses basically work when markets trend and they don't work when markets don't trend. The idea of whether or not you should take a loss as such is based on the probability the market will trend against you sufficiently to take you out of the trade. The other symbiotic concept is the horizontal versus vertical movement in the market.

The real answer is that you may not have a choice on this. There is a limit to any ability to constrain losses.

Last edited by tpredictor; May 19th, 2018 at 06:12 PM.
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