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Kane Trading
on:
Realistic Expectations,
Part II
Warning:
Ouch! You probably don't want to read this. If you do you may have your
(unrealistic) hopes and dreams completely shattered even more.
After I wrote Realistic Expectations I received a lot of
feedback. Since I wrote it, and then after I mulled over the feedback that I
got, I started to think that there were some additional aspects I wished I had
included. I decided to write a 'Part II' and just continue the theme a little
bit more. It is more of the same, and if you did some critical thinking and
assessment with the concepts from Part I you likely already know what is to
come, but in the interest of providing as much educational food for thought as
I can I decided to write this up.
I want to look at another common scenario, or perhaps
better described, a common misconception, with regard to expectations. As I
explained in Kane Trading on: Trade Management (read the book for the
full details), I feel you generally can't get much of an edge on the 'expected
value' curve as you move from low percent winners to high percent winners. As
the percent winners goes up, the reward/risk (see reward/risk note at the
bottom of the article) goes down.
The expected value, a term from probability theory, is
simply a calculation that takes both factors into account. You can't 'beat the
curve'. My experience is that, with very little deviation, you can move on the
curve, but the expected value stays about the same. It becomes an issue of
where on the curve can you find the best fit for you.
For example, a traditional
'scalper' may be looking for a high percentage of winners, say 80%, and can
even trade with a reward/risk less than 1:1. A trend trader may be on the very
low end or the curve, with only 30% winners, and reward/risk numbers of 2:1,
3:1, and even 4 or 5:1. I've seen a few go to 7:1 and even 10:1 on rare
occasions. The problem I see here is in having little or no 'feel' for the
implications of these numbers.
Once a trader has his or her game plan completely down
then these numbers may not come into play in the daily routine. In the 'Trading
Plan' construction phase, though, they are a critical aspect. Like I discuss in
Kane Trading on: Trailing Stops with regard to truly knowing the move
one is trying to capture, in the development phase of a 'Trading Plan' I feel
one should know what it is he or she is trying to do, as far as the plan. What
is the type of move that is being 'stalked', and what do I have to do to
attempt to capture that? What risk i.e. stops and position size, and how
frequently do I expect this to play out?
Let's get to some examples, since this may be
getting too abstract at this point. What motivated me to discuss this specific
aspect is that I commonly hear people discuss reward/risk, and especially
winning percentages in what I consider very unrealistic terms. This doesn't
even get into one of my main pet peeves, and that is this overemphasis on
percentage of winners. I won't discuss this too much here, and hopefully by the
time this article is done the reader will be able to figure out why this
bothers me so much. I will say that the percentage of winners has more to do
with, or should I say is almost entirely dependent on, the trading style, and
reflects the rigor of the 'Trading Plan' to only a small degree, at least as
far as one's ability to use that data to evaluate that rigor.
What I mean is, if
your plan is hitting at 80% winners that doesn't necessarily mean the plan
makes money (the expected value could easily be 'net negative'), it may just
mean the style is a 'scalping' type style. And you may be hitting only 30%
winners, but can't conclude the plan lacks rigor because it may be net positive
outcome, and be making money hand over fist. This one number, percentage of
winners, is essentially useless by itself. Again, I refer the reader to Kane
Trading on: Trade Management for my full thoughts on all this.
Let get on with the
example. I frequently hear people say they want 80% winners, and look for at
least a 2:1 reward/risk. Have you heard that before? It's the most common
scenario I hear. Sure, there is an almost infinite number of combinations, but
let's start with this as our ballpark estimate for 'Joe Average'. I will use
the same general parameters from Part I, with the ES mini. Let's say our trader
does three trades per day, and trades twenty days per month. Let's also say
that he or she makes 2 points and risks 1. That seems more than reasonable.
Keep in mind this is another completely made up example, not taking into
account slippage, commissions, or anything real (or you could say the points
are already factoring that in), and is done just to attempt to grasp the
concepts here.
All of these numbers sound not only totally reasonable, but perhaps
even conservative. It sounds so dull that your average dream merchant wouldn't
even give an example like that, for fear of never selling a single seminar,
software, system, or whatever. This is the starting point for many, many
aspiring traders I have seen post to forums, in chat rooms, and so on. But what
are the implications? Without at least looking at the implications of what is
proposed, we have no idea how realistic they may be for formulating a 'Trading
Plan' around them.
Joe Average trader will do three trades per day, and make 2 points
80% of the time, and will lose 1 point 20% of the time. This works out to 1.4
points net, on average, per trade, from the expected value equation. Doing
three trades per day would net 4.2 points, or in twenty days per month, 84
points per month. At $50 per point, that would be $4,200 per month. Hmmm,
sounds pretty good. But wait. That's $4,200 per month on one contract!
And what is the margin? Well, from Part I we saw it could be as low as $300,
or, using my higher end margin, $10,000. Forget the $300 daytrading margin,
with the full $10,000 per contract margin the rate of return is 42% per
month, or 504% per year, without any compounding.
Now, this sounds just like an
infomercial. But you know I'm going down the exact opposite path right now. Let
me use the same line from Part I, with an adjustment for the current numbers
and name: 'Hmmm, 'super-trader' 30%, Joe 504%. Nope, not happening. Not even
close.' So the trader is beating him or herself up because he or she can't hit
that 80%, and is passing all those trades with an 80% winning percentage
because they don't have that 2:1 reward/risk, and look at what that implies.
And I've seen many infomercials that brag on a lot higher numbers than
this. Get real, folks.
If you are trying to formulate a realistic working plan, and you
are basing your foundation on things that exist only in fantasyland, I doubt
you will ever put together a plan and become a successful professional. I don't
feel this comment is specific to a trading business, it's pretty much
universal. Remember from Part I Pizza John Dough and his plan. Now, let's look
at two more scenarios, in brief, just to give you some additional food for
thought, and hopefully this will help as you work on your own plan.
Let's look at the idea of an edge,
or I might say a realistic edge, and just what that may look like. It's amazing
how small it looks in comparison to the crazy stuff the dream merchants pump
out. I'll use the same scenario we have been using, Trader Joe Average, 3
trades per day, twenty trades per month. Joe wants to know what kind of edge he
needs to make what he sees as 'super-trader' returns of say 30% per year. To
start, we see that he needs 2.5% per month, or about .125% per day. If he does
3 trades per day, he needs an average of about .042% per trade.
For this example I
will look at a 1:1 reward/risk play. What percentage of winners does Joe need
to make his 'super-trader' returns with just a simple, completely unimpressive
1:1 reward/risk ratio? If you understand the math go and do this, and see what
you come up with, and then check that with my work here. Do you have it? What
was your 'gut feeling' before you did the work? 70%, 80%, more? It's just a
fraction over 54%. Yes, at just a 1:1 reward/risk ratio, Joe gets his
'super-trader' returns winning only just over 54% of the time. Recall, again,
that this is a made up example, ignoring slippage, commissions, trading
reality, and so on, just for the sake of studying and trying to grasp the
underlying concepts here.
What does this tell me? It tells me how small a 'big
edge' ('super-traders returns, after all) actually looks like. An 'even money'
bet and only a 54% winning ratio and that's what only a handful of people have
achieved? So, why are so many seminars, program trading packages, and
infomercials talking bigger numbers than we started with? Because they don't
reflect even a hint of reality in my opinion. Again, in my opinion,
there is the dream world, and then there is a real world of attempting to make
it as a serious professional, and that applies to any field. By constantly
working with erroneous assumptions I don't see how anyone could form a
successful plan in any business.
I will wrap up with another example from the 'trend
trading' end of the expected value curve. Let's say you found this great setup
and it really does yield these fantastic 3:1 reward/risk trades. It would be a
stretch, even for a fictitious example like this, to assume Joe Average will
find 3 of these per trading day in his ES, but let's assume that anyway, so we
can make a comparison directly with the work we have done so far. What I want
to know is, what percentage of winners does Joe need to make his 'super-trader'
returns? What does this big edge he is trying to achieve look like?
Do your work here, or make your
best guess, and tell me how often he has to win to be part of this elite
handful? Just a fraction over 27%. What? Joe is banging it out at a whopping
27% winners, 73% 'losers', and he makes the super-trader hall of fame? What?
Yes, that's what a big edge looks like at 3:1 reward/risk. At 5:1 it is just a
fraction over 18%. Please keep in mind how fictitious these examples are. They
are only designed to see the underlying mathematical principles at work here,
much like the old physics examples in school where they ignore friction. We all
know friction exists and plays a part in the actual event, but to learn the
general principles first, you look at a simplified version.
The point I have
been trying to make here is that a small edge looks a lot different than most
people perceive. If you don't even know what the thing you are looking for
looks like, how will you ever create a plan to find it? It reminds me of the
story about the drunk person looking for his car keys under the street light.
Someone goes to offer help and the drunk says he lost them over there, pointing
off into the dark. The assistant says then why are you looking over here, and
he says because the light is over here. You see the point? If you are looking
in completely the wrong place you won't likely succeed.
Now, I'm not trying to sell any
books here, and this isn't a commercial where I then tell you to buy my
products, but I go over a lot of this in Kane Trading on: Trade Management. That
book is a good reference book to get started on how to study this aspect. If
you don't utilize this resource then find another place to get information on
the topic. I just strongly suggest that you don't even think about trading
until you fully understand all this, and understand what it implies for your
trading, and your 'Trading Plan'.
What we looked at today is just one more aspect of why I
say that my 'Trading Plan' is only 10-20% about the setup i.e. the potential
trade area (PTA). Most training focuses on endless discussion of the setup. The
vendor comes up with a setup they feel works (or doesn't even feel works if
they are unscrupulous), and they sell you that setup like it was an entire
'Trading Plan'. That's like selling a pizza recipe and selling it like it was
an entire plan for a successful pizza business. It doesn't tell you much about
getting a store, buying supplies, employees, bookkeeping, taxes, and on and on.
It's just one aspect. So is the PTA, as far as a trading business.
I know most people
don't like math, and they like critical thinking even less than math, but if
you've been told, and believe, that trading as a full-time business is simple,
and requires just being taught one easy setup, and then you are good to go for
the long haul, over all market conditions, well, I'm sorry, but that is not the
case for any business I have ever seen, much less trading.
I actually saw a
post yesterday on a forum where they guy was putting down all the vendors,
saying some talked about how discretion played into trading, and how his only
interest was in a setup that was easy to quantify, looked the same for every
person viewing the setup, and worked consistently. Talk about an unrealistic
view of trading, or any business. If there was such a setup it would be coded
and pounded into submission immediately by the 'hedgies'. In my opinion, and
this is just an opinion, you can only 'beat the market', that is, get an edge,
with talent. With skill. With accurate knowledge and realistic expectations.
With a comprehensive, well thought out plan. I hope that I have contributed
here with some ideas in that direction.
Note on
reward/risk: I've explained this in the books, and in other writings,
but I want to review it here once again. I use the term reward/risk, and not
the commonly used risk/reward. Most people probably don't even catch this, and
I'm sure some think I'm 'saying it wrong'. I do this for one simple reason.
When someone says they have a 2:1 risk/reward, they mean they make 2 and lose
1. They are saying the reward first, the risk second. If you said, for example,
I have a great 1:4 risk/reward on this setup people would say you were nuts,
1:4 is terrible. If we say the numbers where reward is said first, then when we
describe the situation, we should say reward first. If we want it the other way
that's fine, but then let's put the numbers in the right order, saying risk
first. So, ignoring the well ingrained way this has been used, I do it in a way
that makes sense to me.
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