Over the years I have horrified quantitatively orientated seminar audiences by using a coin to predict market direction. I always ask, “would any of you trade with a coin”. They all to a person laugh and dismiss me as a crazy old man.
I then ask, “let’s consider a special game”.
“If you can predict a head or a tail correctly I will pay you twice as much as you are prepared to bet.”
“Would you play that game?”
Mostly the room shakes their head and I confound them by telling them that it’s a great game to play and the basis of all financial trading.
Let’s look at the sums.
You should be right 50% of the time.
That means in 10 spins of the coin and betting 1 pound a spin the result is
5 times 2 ….when you guess correctly
5 times 1… when you guess incorrectly
Thus you make 50 pence per trade. If you can find someone to underwrite that game, you can just keep making money for ever. You have engineered a system with a POSITIVE EXPECTANCY. Trading is no different.
In simple terms, such a system makes more when it’s right than it loses when it’s wrong. There are two parts to the equation above.
- Hit rate ( that’s the 5 out of 10 for the coin)
- Risk to reward ( that’s the twice as much when you guess correctly as you bet)
A 50% hit rate system can make a lot of money when the risk to reward is large, and that’s typical of trend following systems. They will have typically a hit rate of less than 50%, but can have a risk to reward of maybe 5-6.
Please think about the two parts of making money in markets. Most just focus on hit rate and ignore risk to reward. The latter habit causes traders to snap at winners and then find they are unable to cut losses.
As your trading becomes more short term then it, in my opinion, becomes more like playing a game than an analytical exercise. Intraday and swing traders are frequently good backgammon players and enjoy a night on the tables.
Trading with VectorVest gives the trader the best of both worlds in that trades can be engineered that have both a high hit rate and also a high risk to reward.
This results in systems with an enormous positive expectancy.
David Paul
May 19th 2014
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