It is odd to me that this thread became so focused on the subject of a string of outcomes and the odds of the next outcome argument, yet I think that the real important idea at the beginning of the thread was the idea that casinos don’t make there money based on the “edge” of the game but in fact do make there money based when the player runs out of money. Dr. Tharp and Ralph Vince talk about the risk of ruin even in a game 60% in your favour.
Here is a copy found all over the net: http://www.otrader.com.au/dloads/difficultmakemoney.pdf
What this says is that a casino would still win even in a 50/50 game like coin toss.
Also in effect it says if you built an automated trading system that can win 60% of the time, if it bets a big part of your account, it will still blow up your account. We know this as getting through a drawdown.
All that is nothing new . . . but I have been thinking that a stop loss is a little bit like a mini blowing up of your account. You can build almost any automated trading system you like and if you introduce a stop loss in your back-test you will usually get a lower overall return.
In the bigger picture, if the market were full of traders with stops and many other traders with under-funded accounts, it would cause the market to drop faster than it rises, a phenonium we do see in the markets. Like a casino, a draw-down or string of bets loosing means the play must quit, this would cause funds to transfer to the “house” or in the market the better funded pros with better risk management. You can also say new money comes in to the market, but it just bounces around, until someone losses and steps away from the table. Fear and greed come in again. The amateurs would give up on the market just when they should buy. The old floor traders used to say, when you feel like you want to puke on your shoes, it’s probably time to buy more.
I recall years ago learning a fascinating idea, that a stock that has a lot of short interest can rocket up if the shorts get squeezed and they all must cover. Imagine the emotions of someone with a great short but the stock rises anyway (like Netflicks last year). They must feel just like the guy in Vegas when his ATM card says no more money for you. At some point you reach a pain threshold, margin call or just go broke. In a way, it is at this point your money is released back into the trading system. This happens not just to one trader but thousands at once. When the selling pressure is finally off, the stock must do something and when you are all out of sellers that something is the stock goes up in value.
I have thought about how you trade this, and it begins to sound like old trader wisdom, “buy on the pull back” and “keep your powder dry”. It even gets a bit like Warren Buffet. I have built a number of automated trading systems based on simple indicators, but the ones based on price using “pull backs” usually outperform. In a way you are buying at fire sale prices, buying low to sell high later. This really should not be a surprise that it works.
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"If I understand all you do about this indicator, I might not use it to help me make money, but I don't understand what you are talking about, so I use it, and it does help me make money."
i like that quote i added my own twist to it
"If I understand all you do about Patterns, Volume and Indicator's, I might not use them to help me make points, but I don't understand what you are talking about, so I use them, and it does help me make points."
Lets say it factors in RR, whether the Kelly criterion works at all is debatable. Interesting results if you assume b=100 and b=2 at constant p for arguments sake....the practical risk of ruin is rather high using kelly but for high RR the practical risk of ruin gets unacceptably high.
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It depends on your definition of "works", aka your personal goals, but mathematically it's still correct. The whole point of Kelly is that it is the maximum you should ever trade, because trading a larger size increases your risk without increasing your return (in the long run).
Of course, it's also assumes independent trades etc.
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Last edited by Hotch; March 8th, 2012 at 04:42 AM.
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The main difficulty I have with kelly is the limitation to Bernoulli distributions, ie only two possible outcomes. This does not reflect the real world and results in too high bet sizes being suggested by Kelly.