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Trading Mathematics and Trend Following

  
Analysis, Education
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Some quick points, to be making money, Profit Factor must be greater than 1.

  • Profit Factor (PF)
  • = Gross Gains / Gross Losses
  • = (Average win * number of wins) / (Average loss * number of losses)
  • = R * w / (1-w)
    • where R = Average win / Average loss
    • w = win rate, i.e. % number of winners compared to total number of trades

Re-arranging, we have

  • w = PF / (PF + R)
  • R = PF * (1 – w) / w

Sample numbers showing the minimum R required to break-even (i.e. PF = 1, assuming no transaction costs) for varying win rates.

  • w = 90% >> R = 0.11
  • w = 80% >> R = 0.25
  • w = 70% >> R = 0.43
  • w = 60% >> R = 0.67
  • w = 50% >> R = 1
  • w = 40% >> R = 1.5
  • w = 30% >> R = 2.33
  • w = 20% >> R = 4
  • w = 10% >> R = 9

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Predictions vs. Expectations

  
  Education
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There are two VERY DIFFERENT terms to consider when it comes to trading: 1) Prediction and 2) expectation (or confidence) surrounding the prediction. 

Placing a trade involves making a prediction. It is not possible to place a trade without making a prediction, and that is true even for trades that might or might not execute, such as those placed using a stop order or limit order, for example.

Every trader who places a trade does so because the trader believes there is some chance, greater than 0%, that the trade will be beneficial, perhaps based on historical probability (back testing) perhaps based on intuition (years of trading experience) perhaps based on hopes and prayers or possibly based on nothing more than a need to gamble. Whatever the basis, there must be SOME chance to benefit or else the trader would not entertain it. The trader predicts he or she will benefit, or else the trader does not enter a trade order.

No matter what the prediction may be, so long as the EXPECTATIONS for the prediction are based in reality, there is nothing inherently wrong with making a prediction. As long as a trader accepts a 30% win rate, for example, and makes allowances accordingly, there is nothing wrong with taking such a trade. The same is true for trades with 50/50 odds, as long as the trader properly predicts, expects, and is prepared for 50% failures; which is why it is possible to flip a coin and still be successful. 

Many successful traders may say they never predict, when what they may really mean is that they never EXPECT their prediction to come true. Thus they may say things like “I only react” when more accurately they are reacting… to a failed prediction. For, it is virtually impossible to trade without predicting. So, I say to all you new traders out there “Don’t be afraid to predict. Just know how likely it is that you’ll be wrong, and know what to do when your prediction fails!”

Short Term Trading and Day Trading Is No Nostrum

  
  Education
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Consider an excerpt from Trend Following:

When you trade more or with higher frequency, the profit that you can earn per trade decreases, whereas your transaction costs stay the same. This is not a winning strategy. Yet, traders still believe that short-term trading is less risky. Short-term trading, by definition, is not less risky, as evidenced by the catastrophic blowout of Victor Niederhoffer and Long Term Capital Management (LTCM). Do some short-term traders excel? Yes. However, think about the likes of whom you might be competing with when you are trading short term. Professional short-term traders, such as Jim Simons, have hundreds of staffers working as a team 24/7. They are playing for keeps, looking to eat your lunch in the zero-sum world. You don’t stand a chance.

Unfortunately, the flaws in day trading are often invisible to those who must know better. Sumner Redstone, CEO of Viacom, was interviewed recently and talked of constantly watching Viacom’s stock price, hour after hour, day after day. Although Redstone is a brilliant entrepreneur and has built one of the great media companies of our time, his obsession with following his company’s share price is not a good example to follow. Redstone might feel his company is undervalued, but staring at the screen will not boost his share price.

DOs and DONTs of any sort of correction

  
  Education
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DOs and DONTS of a market crash

1. DO notice how cyclical markets are
2. DONT react emotionally
3. DO stick with your plan
4. DONT rely on gurus, shamans or talking heads (1000% Avoid Blue Channels )
5. DO note your own state of mind
6. DONT take actions while in a state of discomfort
7. DO notice the panic around you
8. DONT try to time the markets
9. DO look for signs of capitulation
10. DONT confuse the short term for the long term

Bonus: DO have a sense of humor

13 Things :5 % of Successful Traders Do Differently

  
  Education
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  1. They pursue realistic goals as their returns.
  2. They take decisive and immediate action when their buy or sell signal is hit.
  3. They focus on winning trades and not quantity of trades.
  4. They make logical, informed trading decisions within their system, based on the probabilities.
  5. They avoid the trap of trying to make perfect trades, and instead focus on being profitable in the long term.
  6. They trade the right position size that is within their comfort zone.
  7. They keep things simple and focus on winning trades, not complexity in their trading.
  8. They focus on learning and making small continuous improvements in their trading system.
  9. They measure and track their progress with a trading journal.
  10. They maintain a positive outlook as they learn from their mistakes, and focus on trading with discipline.
  11. They spend time learning from better traders.
  12. They maintain balance in their life by spending time with family and friends.
  13. They love what they do and their passion keeps them going through the rough times.
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