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R:R is misleading (with 2 example strategies)
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Created: by artemiso Attachments:4

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R:R is misleading (with 2 example strategies)

  #11 (permalink)
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monpere View Post
...let's say I have a strategy, which in backtesting says that, based on my entry method, I reach 20 tick targets 90% of the time before my stop of 10 ticks would be hit. So, I set my target to 20 ticks and my stop to 10 ticks, which is 2:1, disregarding slippage, commissions, etc.

This might introduce a spurious curve fitting into the strategy.

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  #12 (permalink)
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Alright, so what is the thesis of this thread?

That using a stop loss generally has a negative expectancy?

That traders (retail) are misinformed about risk, and using stop orders incorrectly? (which might make losing outcomes near deterministic?)


What is the current assumption of an average retail trader with regard to risk:reward?
How is this flawed?

Is there something you propose that might be more useful?


"If I agreed with you, we'd both be wrong."
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  #13 (permalink)
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This thread isn't written for retail trader and any newbie should aware of it. A 10:1 RRRatio system could never played successfully with the current retailer technical capabilities. Your stats can't be created without sophisticated market data access. No one can rebuild or verify them. It would be much better if the TO would share valuable information and market insights and not such scattered thesis.


addchild View Post
Alright, so what is the thesis of this thread?

That using a stop loss generally has a negative expectancy?

That traders (retail) are misinformed about risk, and using stop orders incorrectly? (which might make losing outcomes near deterministic?)


What is the current assumption of an average retail trader with regard to risk:reward?
How is this flawed?

Is there something you propose that might be more useful?



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  #14 (permalink)
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Koepisch View Post
This thread isn't written for retail trader and any newbie should aware of it. A 10:1 RRRatio system could never played successfully with the current retailer technical capabilities. Your stats can't be created without sophisticated market data access. No one can rebuild or verify them. It would be much better if the TO would share valuable information and market insights and not such scattered thesis.

I don't think that's what the OP is getting at, he clearly wanted to convey some information when he started the thread. I think the main purpose of the thread was to provoke people to think about why they use the R:R that they do, and that there may be options that are better suited and actually hold less risk than a standard R:R>1:1.

"If I agreed with you, we'd both be wrong."
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  #15 (permalink)
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Koepisch View Post
This thread isn't written for retail trader and any newbie should aware of it.

I'd say that my thread is written precisely for the newbie. I think a lot of pseudoscience is being peddled out there to milk money (in web ads, trading room fees, book royalties) from the layperson, and it is great to weed out the myths. I'm not asserting that I know any better, but I'm inviting challenges from anyone who disagrees with me. I think the ensuing discussion gives a more balanced argument, allowing for people to weigh the pros and cons of using the R:R, than one-sided claims in favor of the R:R (which some books make).


addchild View Post
I don't think that's what the OP is getting at, he clearly wanted to convey some information when he started the thread. I think the main purpose of the thread was to provoke people to think about why they use the R:R that they do, and that there may be options that are better suited and actually hold less risk than a standard R:R>1:1.

Correct!

There are various techniques, e.g one-day VAR95, that far supercede the R:R. One of the advantages is that it is formulated in a way that actually allows you to assess the risk of a combination of positions/strategies. There are much better techniques and I can talk on forever, but it is easy to calculate one-day VAR95 by historical simulation, making it a gentle entry into a wonderful subject. I gave the example of VXX and XIV - this is classic to anyone who trades ETFs - it makes intuitive sense that going simultaneously long on both poses less risk than going simultaneously long on SPY and SSO, ES and NQ etc. On the other hand, R:R would just tell you that you placed a stop at X ticks away for each position, something you can figure out without introducing useless variables. My favorite reference on this is by McNeil, Frey and Embrechts, but before anyone considers splashing $80+ on the book, there is a free set of lecture notes by Embrechts himself that covers most of the material (in a better manner, too, in my opinion).

Of course, I must warn that these notes were written in 2005. If the material works in practice, then 2007 wouldn't have happened. It still beats whatever random book basically written in 1998 by a psychology PhD.

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R:R is misleading (with 2 example strategies)-embrechts.pdf  

Last edited by artemiso; October 19th, 2012 at 06:59 PM. Reason: Typo
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  #16 (permalink)
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artemiso View Post
I'd say that my thread is written precisely for the newbie. I think a lot of pseudoscience is being peddled out there to milk money (in web ads, trading room fees, book royalties) from the layperson, and it is great to weed out the myths. I'm not asserting that I know any better, but I'm inviting challenges from anyone who disagrees with me. I think the ensuing discussion gives a more balanced argument, allowing for people to weigh the pros and cons of using the R:R, than one-sided claims in favor of the R:R (which some books make).



Correct!

There are various techniques, e.g one-day VAR95, that far supercede the R:R. One of the advantages is that it is formulated in a way that actually allows you to assess the risk of a combination of positions/strategies. There are much better techniques and I can talk on forever, but it is easy to calculate one-day VAR95 by historical simulation, making it a gentle entry into a wonderful subject. I gave the example of VXX and XIV - this is classic to anyone who trades ETFs - it makes intuitive sense that going simultaneously long on both poses less risk than going simultaneously long on SPY and SSO, ES and NQ etc. On the other hand, R:R would just tell you that you placed a stop at X ticks away for each position, something you can figure out without introducing useless variables. My favorite reference on this is by McNeil, Frey and Embrechts, but before anyone considers splashing $80+ on the book, there is a free set of lecture notes by Embrechts himself that covers most of the material (in a better manner, too, in my opinion).

Of course, I must warn that these notes were written in 2005. If the material works in practice, then 2007 wouldn't have happened. It still beats whatever random book basically written in 1998 by a psychology PhD.


I agree these are superior methods of assessing market risk, especially as you increase variables, positions/ strategies/ time ect. But what about the little guy, trading only intraday, on one or two products, with a small bag of tricks. Certainly 1D-VAR is far beyond the required risk in order to trade efficiently in a significantly smaller window.

Do you think 1D-VAR would be more efficient, than your vwap example from your initial post? (Where risk= long entry- short entry.)

"If I agreed with you, we'd both be wrong."
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  #17 (permalink)
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addchild View Post
I agree these are superior methods of assessing market risk, especially as you increase variables, positions/ strategies/ time ect. But what about the little guy, trading only intraday, on one or two products, with a small bag of tricks. Certainly 1D-VAR is far beyond the required risk in order to trade efficiently in a significantly smaller window.

Do you think 1D-VAR would be more efficient, than your vwap example from your initial post? (Where risk= long entry- short entry.)

Very good questions.

There are some things about using VAR that are more like an art than exact science. One of the important ones is that VAR is NOT meant to be used as the "worst case scenario", but rather a minimum loss that you better be prepared to tank every period (if you calculated your 1M-VAR, then this period would be every 1 month). Actually, I think it was Aaron C. Brown - Wikipedia, the free encyclopedia whom I learned this from, and I think he is one of the fewer people in the industry who understand this well (makes sense why he is GARP risk manager of the year). This interpretation makes a lot of sense, like the idea of a maximum drawdown. However, even some important CEOs don't know how to apply this, e.g. Temasek Holdings' Ho Ching in a public statement after a series of huge trading losses that she had a 40b+ VAR at the 84 percent confidence interval in her original portfolio. This is (1) ridiculously high with (2) a considerably low level of confidence!

I'm not too sure about your question with regards to the VWAP example strategy. In this case, one thing the average investor can ask is, "What's the 1D-VAR/1 month-VAR of this strategy?" That easily eliminates a lot of phony strategies like the stochastic 80-20. Another thing is to notice that this is a two-parameter strategy: 3-day VWAP and +/-0.5% spread are used in the entry/exit conditions, and the regular retail investor can apply the techniques that he is used to. For example, it is possible to use the 1D-VAR to optimize the parameters, just like NT would let you optimize it based on profit factor, maximum drawdown etc.

^Except I think VAR is much easier to apply than something like maximum drawdown. Most silly college interns that I had encountered got onto the trading desk without knowing the difference between a 5.0% maximum drawdown and a 5.1% maximum drawdown. I don't blame them - because I don't know either! It doesn't say a lot when you say that the historical maximum drawdown on this strategy has been 5.0 or 5.1%. However, it's more useful and makes a huge difference if you are calculating capital re-allocations and performance fees for the hedge funds that you are managing. Don't quote me on this though, I'm not an expert at maximum drawdown.

There's nothing wrong with making VAR calculations on a single instrument, intraday strategy, it still works well. If you trade equities, there are various ways to use VAR to diversify your portfolio. R:R doesn't do that. I know some would use an Excel spreadsheet to calculate their VAR (and other parameters) offline, then enter their trades intraday, semi-automatically. If you trade options or even equities+options, there is formulation for you to calculate your VAR. R:R doesn't do that.

Lastly, I must re-emphasize that no risk measure is fail-safe. But some are definitely better than others, e.g. I'd prefer relying on R:R over looking at the formation of stars in the sky.

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