A lot of system traders when develop or looking for a trading system would only want a high win rate or high percentage of winning trades (other than high return) thinking that that is the most important thing and will minimise their losses or drawdowns when trading it. I am here to tell you not necessary!
Having a high win rate doesn't mean you will never suffer many consecutive losses (which I'll talk about here) or even the trading system will make money in the long term (I'll explain more maybe in future article)!
But how do I know how many consecutive losses to expect? I'll show you a quick Excel spreadsheet that I hope would help some traders understand trading edge better. The example below shows a system with 70% win rate in a 10,000 permutation simulation with their respective numbers and percentage of consecutive win and loss trades. How many consecutive losses is the maximum in this sample of simulation? 9!!! Multiply that with your average size of losing trade and you'll roughly get the idea of how much minimum starting capital needed in the trading system (plus margin for the number of lots you are trading if you don't want margin call or intraday force liquidation of your positions).
How do you know if you'll start with consecutive winnings first or consecutive losses first? Now who tells you luck is not important in system trading? Lets say you have bad luck, imagine 6 months to go through max consecutive losses when you start then another 6 months trying to climb back to breakeven, that is 1 full year of pain, I can't blame you from giving up on system trading.
Even a system with 70% win rate you may suffer 9 losses in a row! What if during actual trading, the win rate drops to 60%? Will your ratio of average win/average loss big enough to still have positive edge? Or the system will go into losses or stop working which is what usually happened as the win rate that we get is usually fully optimised, a drop in win rate when trading live is almost for sure! What about usual trend-follow system with 30-40% win rate? Can you still take the next trade after suffer 8th consecutive losses? Will telling yourself "fear is not real" help??? Talk is always easy.
Here's the sample screen:
Cheers & Happy Trading!
P.S.: How many max consecutive losses for a system that is 50%? Ever wonder why it is more common than what we expect to see 15 consecutive "big" or "small" in Genting or any Casino? That is why doubling down after losses will never work in the long run. Money management will not help if your edge or average trade is negative!
I think "expectancy" is the key factor rather than win rate and/or high return win amount.
ReplyDeleteGood luck.
Yes, you are right. That is the "edge" that I mentioned. I read even some trading books got it wrong when they were confused by using profit factor in the edge or expectancy formula instead of average win and average loss. Will go into that in the future for the rest of readers when I have time. Thanks for pointing the importance of that out.
ReplyDeleteOh, forgot to emphasize that sometimes you can have same expectancy with different win rates. Given two systems with same edge or expectancy, one with 80% win rate and another with 40% win rate, I'll prefer the second one if both back-test have been done properly.
ReplyDeleteHi Han, im rather new in this. how do you do your backtesting normally? Also, why would you choose a lower win rate given the same expentancy? Thanks.
ReplyDelete