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Why 7% is the Difference between Failure and Success in Trading
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Why 7% is the Difference between Failure and Success in Trading

  #31 (permalink)
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Fat Tails View Post

@liquidcci: You got it wrong, the second model is better because it produces lower drawdowns and therefore allows for higher leverage. But I agree that the result is counter-intuitive.

Attachment 72383


Fat tails I was not using draw down and did not see it in the examples given. Maybe I am reading to fast. I always include drawdown in factoring anything I personally do. My system depends on low draw downs.

I think even if one has better draw down over the other you still have to consider the potential of what depending on a high winning percentage can do to you in a bad run situation outside of a systems norm. I was more looking at how robust the system is or is not. If I can breakeven at 35% and make money handover fist at 60% I stay in a good mood.

"The day I became a winning trader was the day it became boring. Daily losses no longer bother me and daily wins no longer excited me. Took years of pain and busting a few accounts before finally got my mind right. I survived the darkness within and now just chillax and let my black box do the work."
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  #32 (permalink)
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liquidcci View Post
Fat tails I was not using draw down and did not see it in the examples given. Maybe I am reading to fast. I always include drawdown in factoring anything I personally do. My system depends on low draw downs.

I think even if one has better draw down over the other you still have to consider the potential of what depending on a high winning percentage can do to you in a bad run situation outside of a systems norm. I was more looking at how robust the system is or is not. If I can breakeven at 35% and make money handover fist at 60% I stay in a good mood.

As far as my understanding goes, @Anagami has presented Monte Carlo Simulations. The worst path on the chart allows for an estimation of the maximal drawdown.

Bad runs are accounted for in that simulation, as the order of the trades is different for every path. The point I am trying to make - and this is understood by very few traders - that the second system, the one with the high win rate and the 1:1 average win to average loss is the better option because

-> it produces smaller drawdowns (your intuition here is false!)
-> can support a higher leverage with equal risk (in particular in a bad run situation)

Both the model that I use and the Monte Carlo Simulation by Anagami have confirmed this with a completely different approach (one is theoretical the other experimental). Ralph Vince has written this again and again, but nobody seems to understand the mathematics.

Of course an edge is an edge, but look at the pictures of the simulation and you should understand. Two systems having the same expectancy, but the second has the better Optimal F!

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  #33 (permalink)
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Fat Tails View Post
As far as my understanding goes, @Anagami has presented Monte Carlo Simulations. The worst path on the chart allows for an estimation of the maximal drawdown.

Bad runs are accounted for in that simulation, as the order of the trades is different for every path. The point I am trying to make - and this is understood by very few traders - that the second system, the one with the high win rate and the 1:1 average win to average loss is the better option because

-> it produces smaller drawdowns (your intuition here is false!)
-> can support a higher leverage with equal risk (in particular in a bad run situation)

Both the model that I use and the Monte Carlo Simulation by Anagami have confirmed this with a completely different approach (one is theoretical the other experimental). Ralph Vince has written this again and again, but nobody seems to understand the mathematics.

Of course an edge is an edge, but look at the pictures of the simulation and you should understand. Two systems having the same expectancy, but the second has the better Optimal F!

Fat tails not sure what you mean by my "intuition". I am not using intuition I was looking at a limited set of facts and not including draw down in my response. So I was not looking at the way you are looking at it when I posted my response. I was making a very narrow specific point about using a system that needs a high win ratio to be profitable.

I understand the math and use fixed ratio in my trading. 90% of my profits come increasing my contracts thus I need low draw downs. I shoot for systems that are robust that need fairly low winning percentage and can take a beating. I must have low draw downs so I can leverage.

"The day I became a winning trader was the day it became boring. Daily losses no longer bother me and daily wins no longer excited me. Took years of pain and busting a few accounts before finally got my mind right. I survived the darkness within and now just chillax and let my black box do the work."
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  #34 (permalink)
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liquidcci View Post
I understand the math and use fixed ratio in my trading. 90% of my profits come increasing my contracts thus I need low draw downs. I shoot for systems that are robust that need fairly low winning percentage and can take a beating. I must have low draw downs so I can leverage.

I understand as I am in the same camp in trading style with ES..

Fat Tail's analysis is also correct. I learnt that the hard way,more loss of time than anything else, where I was using a similar example as #1.

Trader

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  #35 (permalink)
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I liked that risk of ruin thread and the realization that the winning percentage had a larger impact. Thinking of it simply: Would you rather have to deal with a 1x draw down 60% of the time(40% winners) or 40% of the time(60% winners)? 40% of the time sounds better to me because statistically there are going to be smaller strings of 1x losses put together compared to 60% of the time. Thus lower potential for draw down.

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  #36 (permalink)
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Luger View Post
I liked that risk of ruin thread and the realization that the winning percentage had a larger impact. Thinking of it simply: Would you rather have to deal with a 1x draw down 60% of the time(40% winners) or 40% of the time(60% winners)? 40% of the time sounds better to me because statistically there are going to be smaller strings of 1x losses put together compared to 60% of the time. Thus lower potential for draw down.

I was astonished as well the first time that I realized that the winning percentage prevails over the R-multiple, but in the end it is just mathematics.

The concept for Optimal F points you into that direction, although the model is only valid for Bernoulli distributions.

A Monte Carlo simulation - let us say an experiment - confirms the finding for a more general case. So you know that the risk adjusted returns of the strategy with a low R multiple but a high winning percentage are better. This allows you to use a higher leverage and in the end you will attain your goal with only half the trades.

This is really astonshing and I cannot easily grasp it with my mind, but then I don't have to, the model states it and the simulation of the experiment confirms it.


Last edited by Fat Tails; May 4th, 2012 at 06:07 AM.
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  #37 (permalink)
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I'm currently trading above 60% win rate and going into each trade with a 1:1 mindset, though each is managed uniquely as the trade evolves. I tried for a long time to think in 2:1 terms, but the question is does the market make this easily available. I think not. If every trader in the market is trying to achieve 2:1 how does it add up. The fastest of the HFT are definitely going to get these opportunities if when and where they exist. Perhaps the best game you can actually get from the market is 1:1, makes more sense. I do not trade forex but had a look at some webinars from one very successful trading room with a long and profitable track record for scalp trades. There they have a negative risk reward and go for the 70% plus winning rate. Their mantra is that the market does not give a better than 1:1 to anyone. Anyways, getting base hits and keeping that win rate high will give you far more confidence which will give you the real edge each time you step up to the plate, staying cool and in the trade and not worrying about where your back ratio'd stop is supposed to be...

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  #38 (permalink)
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Fat Tails View Post
As far as my understanding goes, @Anagami has presented Monte Carlo Simulations. The worst path on the chart allows for an estimation of the maximal drawdown.

Bad runs are accounted for in that simulation, as the order of the trades is different for every path. The point I am trying to make - and this is understood by very few traders - that the second system, the one with the high win rate and the 1:1 average win to average loss is the better option because

-> it produces smaller drawdowns (your intuition here is false!)
-> can support a higher leverage with equal risk (in particular in a bad run situation)

Both the model that I use and the Monte Carlo Simulation by Anagami have confirmed this with a completely different approach (one is theoretical the other experimental). Ralph Vince has written this again and again, but nobody seems to understand the mathematics.

Of course an edge is an edge, but look at the pictures of the simulation and you should understand. Two systems having the same expectancy, but the second has the better Optimal F!

Yes, that's exactly right.

Being an empiricist and more of a visual thinker, I took the Monte Carlo path... and I am surprised that the traditional maxim of "let your winners run" and "your winners must be bigger than your losers" is not necessarily the best... The 60% winner at 1:1 is better because of lower drawdowns... which allows one to crank up the leverage (which ought to be a big consideration because we can reach our goal faster). I should also add that 60% win rate makes trading a more psychologically enjoyable experience.

Later today, we'll look at a third alternative, scalping, with 1:0.5 RR.

"...the degree to which you think you know, assume you know, or in any way need to know what is going to happen next, is equal to the degree to which you will fail as a trader." - Mark Douglas
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  #39 (permalink)
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Scalping

There is one last possibility to explore, and that's scalping. I define scalping as a trading style where one is playing for gains smaller than risks. For the purpose of this particular experiment, we will consider scalping to be trading with the RR 1:0.5. In other words, the profit size is only 50% that of losses.

This is an inversion of classical trading advice such as "let your profits run"...etc. (Notable exception among classical 'market wizards' being Mark Cook, who trades with this ratio.)

Case 1: 66% Winning (Random)

Again, we start with Random. We need to improve to have a chance.

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Case 2: 70% Winning (Slightly Improved)

If we improve by 3%, the result is noticeable but not strongly so. Hitting 70% at a scalping RR won't do the trick. It's not good enough, and vig will eat us alive.

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Case 3: 75% Winning (Profitable)

If we improve only 5% more, things get interesting.

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We are definitely profitable now. There are almost no trials finishing below the starting point, and about 90% of the graph is in the upper area. We can beat vig now and then some. The ratio of MAX VAL to MIN VAL is now 5, indicating that we have reached a profitable point. We will come back to this case later for comparison purposes.

Suppose we improve further. Instead of winning 3/4, what if we win 4/5?

Case 4: 80% Winning (Expert)

Improving additional 5% has a tremendous impact on the performance.

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We not only finish above the starting point in every trial, but quite a bit so. The MAX VAL/MIN VAL ratio has now risen to a very impressive 12. We are expert scalpers and sky's the limit... well, until the next level.

Case 5: 85% (Master)

Steep curve with a MAX/MIN ratio of 18. The problem now is not how to make money. It's how to spend it.

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Is this possible? Perhaps for a master scalper, picky, experienced, and patient.


Summary

What interests me most at this point is the performance at the 75% winning level with RR 1:0.5. Previous we discussed 40% at 1:2 RR and 60% at 1:1 RR. Let's look at the charts together:

1. 40% at 1:2 RR
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2. 60% at 1:1 RR
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3. 75% at 1:0.5 RR
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I'm not sure where the optimal f is for #3 (Harry, could you calculate it please? (@Fat Tails)), but here is my reasoning:

#2 and #3 seem very comparable to me visually.
#2 has greater MAX and MIN excursions, but the ratio is higher than the ratio for #3.
#3 can have nasty drawdowns when losses bunch because of its loss size relative to gain, but these should happen quite infrequently (impact on leveraging??).

For me, the overriding factor for deciding between these two would be a psychological one.

It's much more enjoyable experiencing 75% winning trades than 60% winning trades (even if winners are half). I like to create a positive psychological feedback loop: the more I win, the better I am inclined to trade. Other traders may have a different preference, but I feel this is probably true for most of us.

I did not discuss how the drawdowns would affect the leverage (and therefore profitability), as I am not certain about the optimal f of #2 vs. #3.

But in the end, I seem to be making a case for scalping.

"...the degree to which you think you know, assume you know, or in any way need to know what is going to happen next, is equal to the degree to which you will fail as a trader." - Mark Douglas
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Anagami View Post
I'm not sure where the optimal f is for #3 (Harry, could you calculate it please? (@Fat Tails)), but here is my reasoning:

#2 and #3 seem very comparable to me visually.
#2 has greater MAX and MIN excursions, but the ratio is higher than the ratio for #3.
#3 can have nasty drawdowns when losses bunch because of its loss size relative to gain, but these should happen quite infrequently (impact on leveraging??).

For me, the overriding factor for deciding between these two would be a psychological one.

It's much more enjoyable experiencing 75% winning trades than 60% winning trades (even if winners are half). I like to create a positive psychological feedback loop: the more I win, the better I am inclined to trade. Other traders may have a different preference, but I feel this is probably true for most of us.

I did not discuss how the drawdowns would affect the leverage (and therefore profitability), as I am not certain about the optimal f of #2 vs. #3.

But in the end, I seem to be making a case for scalping.

@Anagami: If you talk about optimal f, the results will be terrible for scalping, once you include

-> the spread as created by using stop market orders (stop loss) and limit orders (profit target)
-> slippage
-> commissions

You cannot make any case for scalping if you use any realistic mathematical model. Below is an example which shows two systems, both with a winning probability of 60% and a R-multiple of 1. The first system uses a target and a stop loss of 10 points, the second system uses a target and a stop of 20 points.

The results are appalling. The 10 point system requires 6302 trades to achieve the target of doubling the account, the 20 point system only 218 trades. Even if you take into account that the 10 point system will generate about 4 times as many trades than the 20 point system, it will only have generated 872 trades out of 6302, when the 20 point system is already done.

Spread, slippage and commissions have a huge impact on scalping systems, this is the reason I never will do scalping with my retail account.

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Last edited by Fat Tails; May 4th, 2012 at 01:04 PM.
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