In Part 6 – What to expect…
Why do you make money? What are your strengths and what are your weaknesses? To improve your trading, it is first important to identify what is wrong with it. For a mechanic to repair a car is a very simple task. Most mechanically minded people can replace a broken part, but it takes skill to identify which part needs to be replaced.
With your trading, there is no point focusing on fixing your entry points if your exit points are the problem. To identify the areas to focus on, some numbers become very important to analyse your trading.
Is the strategy profitable or not? The reason you are trading is to make money so does your strategy work?
The percentage return is usually measured annually, so if your return in three months has been 20 per cent, then multiply it by four to obtain your annual return of 80 per cent. If you received 20 per cent over two years, divide it by two to obtain an annual return of 10 per cent.
The hit rate is how often you are right. It is calculated by dividing the number of wins by the number of trades. It shows how often your entry strategy delivers a winning trade. If your hit rate is very low, then you may want to focus on improving your entry strategy. The hit rate is similar to the win/loss ratio and provides the same information.
The hit rate cannot be considered in isolation because the edge ratio is also important. A low hit rate can be profitable if coupled with a high edge ratio. A low hit rate makes the strategy much more difficult to trade because the trader is likely to make losing trades before getting a winning trade.
The risk reward is calculated by dividing the average win by the average loss. This shows how much you make when you are right as opposed to how much you lose when you are wrong. The risk reward will help you determine how profitable your exit strategy is. When coupled with the hit rate, it will allow you to determine the profitability of your trading strategy. The risk reward can be called the hit rate or the average r multiple.
By understanding how to measure trading results you can assess the validity of a trading strategy quickly and effortlessly with a few simple numbers.
Consider two everyday examples of using the risk reward ratio.
Most people have bought lotto tickets at some point in their life, however is lotto the way to riches. The risk is very low, let’s say $10 for a ticket, while the reward is potentially huge, with first prize being many millions of dollars, we will use $10 million for our example. The risk reward ratio of this investment is exceptional at 1 to 1 million. There are very few investments that deliver this kind of risk reward.
But there is a problem with buying Lotto tickets as an investment strategy. It is not the risk reward, but the hit rate. If a winning Lotto ticket requires 6 correct balls out of 40 possibilities, then the odds of winning are 1 in 3,838,380.
If we were to play Lotto 3,838,380 times then we would expect to win once and lose 3,838,379 times. This means we would win $10 million once and lose $38,383,790. Overall, buying Lotto tickets is not a profitable investment strategy. Luck will favour some people in Lotto, but successful investing is not about luck, it is about exploiting profitable opportunities.
In the Super 14 rugby series, (Super 12 until 2006) the Crusaders have been a dominant team over the last ten years winning 7 of the 10 series. In 2008 a gambler placed a $100,000 bet on the Crusaders to win a game at odds of just 1.08. This means that if the Crusaders won the gambler would have received a payout of $108,000, making a profit of just $8,000, but if they lost the gambler would lose $100,000. This is a lousy edge with the risk reward ratio of 100 to 8 and a potential big loss for a very small gain. But the probability of the Crusaders winning the game is very high.
For this to be a profitable investment the odds would have to be over 90% that the Crusaders would win the game. If the odds were 95% then the gambler would lose only once out of 20 games so he would make $8,000 times 19, $152,000, and lose $100,000 once. As an investment even though the risk reward is lousy, this could be a profitable strategy if the hit rate is high enough to justify the investment. Unfortunately for the gambler the Crusaders lost the game, even though they went on to win the competition.
A speculator will find a strategy that skews the odds in their favour and then implement that strategy to generate profits. To calculate your risk reward, look at a series of trades that you have completed.
How often are you right? Divide this number by the total trades to calculate your hit rate. A hit rate of 50% or higher is acceptable. A hit rate of 30% can work provided your losses are kept very small.
A hit rate of 70% or higher is very good. Remember no strategy works every single time. Then do a comparison of your average win to your average loss. Your average gain should be 2 – 3 times your average loss. If it is higher than this then you are trading exceptionally well. If it is less then your margin for error is very small. If your average loss is greater than your average gain then it is back to the drawing board to determine a more profitable strategy.
Enjoy the business of speculation. It is very far removed from gambling at the casino, however a lot can be learnt from the gamblers. It is possible for professional gamblers to win gambling and it is much easier for professional traders to win speculating. Manage your risk and skew the odds in your favour by cutting out your losing trades. It is one of the greatest businesses in the world, yet very few people ever take full advantage of the potential that is available. Start your business today.
Coming up next…
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