How Difficult is it to build a Winning Trading System? (Part II)
“Insanity is to do the same thing and expect different results”
Albert Einstein
This is the second part of a series of posts that we will share with you here and its all about how difficult it (or not?) to build a winning trading system, as the title says. In this part, we will try to examine what are the basic building blocks and the philosophy that is needed to create a winning trading strategy.
According to our humble opinion (that we are entitled to have after so many decades in this business), trading the financial markets nowadays is not different in any perspective about trading back in 1987 or 1999 or 2007 or 2013. I know, again, that many people would disagree with this opinion, claiming that “now the markets have different microstructure”, “the markets because of the rapid technology evolution became more efficient”, or “we never have had COVID-19 before and its pandemic”, etc.; My answer to all these arguments is one: the market is always the same because it serves two processes that they will never change until the end of time: a) the equilibrium between supply and demand and b) price discovery through that equilibrium. Every moment of time something is changing in the world’s economy or geopolitical statuses of sovereign nations. Wars, pandemics (either in animals or human beings), depressions, “Brexits”, “Grexits”, financial crises which almost blew up the planet’s financial system like the one in 2008 or natural disasters like the earthquake in Japan back in early 2011, well known as “Fukushima’s meltdown”. Hence, the environment keeps changing but not the markets themselves, through time.
However, the price of a tradable can either go up or down or sideways. And us-speculators- are interested only in price fluctuations, that via the act of trading we try to make a living out of this game. Now, systematic trading (computer automated or manually executed) serves the need for a certain plan or in other words of a “system” that the purpose of its existence is to exploit those fluctuations, buying risk and aiming for profits as the reward of this risk. Besides and to avoid any kind of misunderstanding here, as “trading system” we define a certain series of rules which a human or a computer (in form of an algorithm) follows and executes without ANY kind of deviation or discretional human intervention in their trading decisions or their actual trades were taken.
Now, “what causes these price fluctuations?” “Shifts in demand and supply”, is the answer. “And what causes the shifts in demand and supply?” “Present needs and future perception about the changes in the price”, is the answer again. “OK, all these make sense, but how could we create a system – strategy that we can always follow and make always profits?”. The answer to the last question, is “you cannot make something like that”. There’s no system, plan, algorithm, machine, or whatever else, that can produce winning trades all the time. That’s impossible and take my word for that. That’s the bad news. The good news is that you do not need a “Holy Grail”, in a form of a trading system. The only thing you need is that system to have one single characteristic: mathematical positive expectation.
Now, what exactly does “mathematical positive expectation” mean? It is simple: Over the long term the number of losses plus commissions (plus broker’s slippage) in monetary terms expected to be surpassed by the number of wins expressed in monetary terms aka profits.
Well, before I mentioned the word “mathematical”. So, to be consistent with my sayings, and a man of my word here’s the mathematical expression which comprises all the above:
π = [(nw x AvgW) - (nl x AvgL)] - C
Where π is the total profit in money terms, nw is the number of winning trades, AvgW the amount of the average winning trade, nl is the number of losing trades, AvgL the amount of the average losing trade, and with C we denote commissions, fees, and slippage. The beauty of mathematics is to “say” a lot of things with just a few lines.
Now, if our trading system produced 1000 trades, and the number of winners is 500 and equal with the number of losing trades, then if we win just a dime more on average than we lose on average, we can easily understand that we have a trading system with a positive mathematical expectation. The higher the number of the historical trades of our system the higher the probability of this expectation to be valid. From the above equation, we also understand one other important thing about trading. It doesn’t matter the % of losing vs winning trades. For example, we may have a 90% winning percentage and in the rest 10% to lose our pants if the average amount that we lose in trade is greater than 9 times from what we win on average. Hence, don’t ever get over-enthusiastic about the success rate of a trading strategy. What you also need to know and value is the average win/loss per trade.
The dream of every trader is to have a trading system that has a 50% success rate but a 2:1 ratio of the average win divided by the average loss. Let’s use some simple arithmetic: assuming we have $1000 that we would like to invest on our trading system, if every time we trade we risk $1 of our capital to get $2 (2:1 reward over risk ratio) and we have let’s say 45% success rate (less than 50%), then after 1000 trades our profits will be -according to our equation above- $350, and therefore our capital will be $1350, a return on investment of 35%. Not bad.
Our job now just narrowed in finding a trading system with similar or even better characteristics. It is not so difficult, especially for the retail side of the market (price takers and not price makers), to find such a strategy with this kind of metric. And here is where exactly a retail trader has an advantage over an institutional trader; his orders don’t affect the market’s price on the contrary when huge funds or colossal companies place trades. I, you, and Joe in the next corner could just profit from this “tide” of volatility that the “big boys” create now and then. We need to be careful, determined, discipline to our system rules, and most of all not greedy. That’s how we will stay in the trading game for a long-long time. Manage our risk before we fantasize about our potential rewards, be patient, and numbers will do their work. Because you never know the distribution of losing and winning trades. You may have 10 winners in a row or 10 losers in a row. The first creates a lot of euphorias and the second may create a lot of disappointment. However, we should have neither, if we would like to have a good trading career.
Finally, one thing is certain: the trading game is not for everyone. And that comes out from the statistics published by the brokers or from the market regulators, from time to time. More than 75% of retail traders lose money instead of winning money. The conclusion is that to be a winning trader is to belong in a minority and not in the majority, like some other things or situations in real life. Trading differs and so are we.