Fundamentals of a trading system — 1
After becoming a full time trade for almost 3-quarrters of an year, I am writing this piece to share what little I have learnt in this trading journey.
The objective of this piece to enable readers to evaluate and assess more data from a Crypto Twitter (CT) guru, and a paid group to fairly assess their subscription value in the long term. It shall also guide the readers to develop their own system and evaluate it, rather than take the word of a third person article like this one. I hope this allows youto become more independent traders in the long-term rather than depend on clout chasing gurus.
Accuracy is the most pitched number by the gurus, but what they do not mention is the Return on Investment (ROI) from a large amount of their past trades - whether their prediction gives positive returns in the long term or not. In order to evaluate the system we need numbers and stats beyond just an accuracy that can provide us more confidence about the future.
To illustrate, let’s assume a hypothetical system where our accuracy is 65% in correctly picking the trade. For simplicity, let’s assume we make an average 2% on all these trades — this is simplified to avoid discussion on probability distribution etc. and other aspects of data-science. Furthermore, let’s assume our remaining 35% trades make a loss of 5% each. Excluding commissions of the trade and margin funding this system would give us an overall loss of -45%, i.e.(65*2 — 35*5).
However, one does not realize this unless he has been sucked really hard for a long time by the paid group. By then, you develop a Stockholm syndrome with the group — i.e. you fail to recognize their flaw and are emotionally invested to recover what you lost in that group. In order to avoid this trap and help you provide more tools to judge a paid group performance, I am going to discuss some parameters in this piece.
A few parameters are self-explanatory — Number of trades in the system, Net Profits, Average win, Average Loss, Largest Loss, and Reward to Risk. So, I won’t spend time to explain them. The remaining names I will explain alongwith the significance they have for trading. At the conclusion, I will present numbers from one of my systems for Silver and Bitcoin to illustrate why accuracy doesn’t matter at all. Hopefully, at the end of the blog, you are equipped with more weapons to ask your guru to provide you better value for your subscription.
Max Drawdown:
Drawdown is the difference between your maximum peak in capital and its current value. This can never be a positive number because with every new peak in your capital growth, your drawdown is reset to zero. Max drawdown is the value of biggest difference between the peak of capital and the bottom of capital on its right, i.e. min bottom after the maximum peak was achieved. This is important because it can help you assess the leverage you want to use with the liquidity you have with your broker.
Sharpe Ratio:
This is a complex number to understand. After all, the person was awarded the Nobel prize for discovering this. So, it is also a very important number. It basically helps you evaluate if you are better off investing, or trading with your strategy. A positive Sharpe ratio indicates that you are getting more return on your working capital than if you let it be in a bank. Do not be surprised if more CT gurus cannot or do not provide you this number.
In my opinion this number is what differentiates a trader from an investor. My systems are providing me Sharpe Ratio between 0.3–0.8 for different assets. I am happy with them but not content because a good trader averages between 1- 2.5 and great traders above 2.5. High Frequency Trading (HFT) firms like Renaissance Tech have this ratio above 10.
Profit Factor:
It simply tells you how much dollars you made for every dollar you risked. Its different from Sharpe ratio. As an exercise for your mind, think about it — why and how is it different?
Percent profitable:
In simple terms this is the accuracy of your system, i.e. the ratio of correct trades to incorrect trades. Contrary to the article, I find accuracy is of little importance if you have good risk management. This will be evident from the numbers of my trading system presented at the end.
Now, we get to the more important numbers. If your paid group has these numbers correct, then you only have to do the most important thing in trading, i.e. Nothing.
If the next two numbers are good, then you have reason to be less anxious about your system in the long run because these numbers tell you about the future returns from your system.
“At the heart of all trading is the simplest of all concepts — that the bottom-line results must show a positive mathematical expectation in order for the trading method to be profitable.” Chuck Branscomb
Expectancy:
In order to achieve the above mental state of nothingness, one should know what the expectancy is of his system. Trading expectancy is calculated over a large number of trades, and provides a statistical number of your ROI per dollar you can expect in the future. To calculate your trading expectancy, you need to know three things — your win percentage (probability of win), your average win, and your average loss. The calculation is as follows:
Expectancy = (Probability of Win * Average Win) — ((1- Probability of Win) * Average Loss)
Knowing your expectancy gives you a trading edge. Knowing this does empower a trader psychologically because he can let his system run for himself for a longer period of time instead of micro managing. Because, this number provides a trader with what he can expect from his trading system, it also gives him confidence. This confidence allows the traders to take higher risk as the system progresses forward, with proper risk management.
I can vouch for this, and as a data-scientist myself, now, I spend more time in exploring new strategies, while my system trades for me.
If you have the parameters for expectancy, you can also get your Reward to Risk for your system:
Average win size/Average Loss size
Now, we know the parameters that provide us with:
· Are we profitable in the long run
· What is my return of investment (ROI) on the total amount I risk
· Is it better to invest or trade
· How much can I lose in the worst case
The last parameter required is how good is the system with respect to changing value of the portfolio — particularly losses — and how does the system change as we progress to more trades? To understand this, we need to know Expectation of the sysstem.
Expectation:
Expectation reflects how robust a trading plan is by measuring how sensitive it is to changes in average loss. The greater the ratio of expectancy to average loss, the higher the expectation. With high expectation, small changes in average loss will have little effect on our net profits. As this ratio gets smaller, however, small changes in average loss will have a greater impact on net gains.
Expectation = Expectancy / Average loss
Some good rules of thumb for expectation are:
· If expectation is less than 0, then the expectancy (gain per trade) must be less than 0 and it is a losing plan that should not be traded.
· If expectation is between 0 and 0.5, then the plan is OK, but we should monitor our losses to make sure the average does not significantly change (get greater).
· If expectation is greater than 0.5, then we have a robust trading plan.
Expectation Score:
The Expectancy Score factors in a trading system’s trade frequency. The different number of trades over different periods of time affects this parameter significantly. The higher the Expectancy Score the more profitable the system. This final score allows you to compare very different trading systems.
Having mentioned these parameters, below are the numbers from my system for Silver and Bitcoin. You can see that although my accuracy (Percent profitable) is way lower than the amount mentioned here, but it is profitable. Also, because I have all these parameters for my strategy/system, low time frame fluctuations in the market do not affect my mental state. I use the excess time to explore/develop more strategies and develop this further.
‘The most important thing in trading is to do nothing’ — Anonymous Internet quote.
You can easily achieve this quote if you build your own system, or buy a system with good values for the above number. Another advantage of a system is that you can use it to benchmark with other systems you will discover as you grow into trading and gain experience into it.
Hopefully, this article helps you improve your trading, and makes you do your own research.
Disclaimer: This article is not a financial advice of any kind.