Help with a Friend

[jonbig04 10]

A friend of mine is just starting to trade (aren't we all) and in trading YM he has discovered that if he uses a 20 point stop, and a 6 point target, he will make money. Now, to me, nothing could be more ridiculous. The fact is though that he seems to be green over the past few weeks. Of course the large stop gives him very high accuracy, enough to be profitable over the past few weeks. But to me this seems very unsustainable, I mean risking 20 to make 6? However I can't seem to convince him. He says the negative r/r doesn't matter because the accuracy makes up for it. What would you tell this person? Am I wrong for trying to steer him clear of what looks to me like a huge dead end? My accuracy has been around 25-28%, taking trades with a risk reward of 1:8 to 1:10 so this goes against everything that I do. Any ideas?

[MidKnight 12]

One can't really say if he is wrong without more information. How large is his sample of trades? What is the % winner? Does he either take the stop or the target, or is that just his initial placement when the trade begins and then it is modified later. Most successful scalpers that I know of do have the r:r in reverse or at beast 1:1. I've seen many that have it at 2:1 or 3:1. Its just another way to do it. Both ways can work.

[jonbig04 10]

He takes 12 or so trades a day, for the past 3 weeks or so. From what hes told me winners are usually around 80%. His r/r is 3.33:1. It just seems insane to me.

[brownsfan019 17]

Risk-Reward is one of those things that some live and die by and others can ignore. Both schools of thought can make money and both can lose.

 

With an inverted Risk-Reward it's then a matter of winning %. If that is high enough regularly, then you can make money no problem. It could actually be easier for some to do it this way b/c they are constantly winning, constantly pulling $ out of the market. Of course, a stop out will put a damper on that winning attitude.

 

With a standard Risk-Reward, winning % is marginally important. I am more on this side of the equation currently in my trading. I'm seeing approx a 40% win rate in these markets but getting rather large wins on the winners. That's the tradeoff I am willing to make - reasonable stops with decent sized targets. My stops will more than likely get tripped more than the other scenario, but for me personally it's a little easier to put the stop where it 'should' be and then re-enter if need be vs. putting a large, random stop on and hoping it holds.

 

But your friend can make money at this as long as the winning % is high enough to offset those 20 pt losses. I wouldn't make the assumption it can't be done - it can, but will be difficult at times.

[MidKnight 12]

Keep your mind open John. Many many ways to make trading work. The numbers you showed though, has a negative expectancy. He needs better than 80% or a slightly less inverted R:R to make money. What he has now will lose money due to comms in the long run if the numbers you gave are stable.

[Hlm 10]

It doesn't have anything to do with negative or positive risk reward. It has everything to do with positive expectancy.

 

Assuming 3.33:1 and 80% ...going off of 30 trades...

 

Wins: +24pts (24*1)

Losses: -20ts (6*3.33)

Profit = +4pts (appx)

 

But like MidKnight said, your commissions would have to be less than $0.67/rt to make money in this simple example.

 

However, there is still one piece of the puzzle missing. Commission only comes into play per transaction. So if his strategy was going for much larger swings, then it could be profitable strictly by the numbers.

Edited February 5, 2009 by Hlm

[zdo 20]

slighty but

 

Odds are it will be <> 20, not 20 tick losses that take your friend down...

(...especially the > 20 variety)

 

...now how would I know that ?

[zdo 20]

More how would I know that ?

 

Tell your friend to refine it to at least 1:2.1 w/l size and >93% w/l rate

and get very proficient in sizing mm - then he'll have fun at his game...

[jonbig04 10]

Thanks for the input guys. I guess mathematically its possible to succeed with such a negative r/r. So i'll let him know that some people can do it, but I still won't recommend it. As far as Im concerned, with the leverage of futures there should be only 4 types of trades: small losses, small wins, medium wins, large wins.

[sevensa 10]

As HLM's has mentioned it is all about positive expectancy. Have you calculated yours? You might be surprised in that with your low accuracy, that your expectancy might be pretty similar to his. There are many ways to skin cat.

[Kiwi 16]

Thanks for the input guys. I guess mathematically its possible to succeed with such a negative r/r. So i'll let him know that some people can do it, but I still won't recommend it. As far as Im concerned, with the leverage of futures there should be only 4 types of trades: small losses, small wins, medium wins, large wins.

 

 

Don't do it John. That's magical thinking - anyone would think you liked Macs or something.

 

It is all about expectancy. A sub 1:1 system can be better than your 2+:1 system. Just teach him about expectancy and his options. Then he can use evidence and analysis to find out what works and go with that. He won't thank you if you get him to change because of your beliefs and then he can't ever really make it work.

 

Science vs Religion > Science must triumph.

[jonbig04 10]

Hmm. I still don't buy it. Maybe if someone comes in here who trades consistently with such a negative r/r. A run of bad luck would set you back horribly. It's true than I'm bias because I see the ridiculous amounts of money that can be made by letting your winners run, but still risking 20 to make 6 day in and out, or cutting your winners and letting your losses run, seems like constantly dodging speeding cars on a freeway to pick up pennies. The size you would have to be trading to make it worthwhile, and if trading size what 3 or 4 stops would do to your account...I shudder to think. Especially for us noobs. I realize this is subjective, but having to hit 8 out of 10 trades just to stay green seems tough. Today for example, my net was -1 ES. I went long at around 9:50ish at 819, and was quickly owned. My target was at Ghigh, 12 points away. Now I will miss that trade most of the time, about 7.5 out 10, so we all know the math, but more importantly...I'm a friggin noob. My accuracy is only going to get better. Imagine the math at 50% accuracy , with r/r's from 1:8-1:12. To me that's the end goal-to risk the least and make the most, and I will ever have to risk a lot on a trade to progress. Granted, all that is subjective. I know the term risk can be skewed a lot of different ways too. Why make trading tougher than it is by risking a lot to make a little?

[Kiwi 16]

It might be time for you to take an evidence based look at it.

 

Look at his system. Analyze his results. Recheck with Monte Carlo.

 

You might well find that his risk of ruin is considerably lower than yours for a give risk percentage per trade. Perhaps with his high win rate and the resulting reduction in probability of a sequence of losing trades he can thus risk more per trade for the same risk of ruin.

 

Evidence not faith leads to better business decisions.

[MidKnight 12]

And may I add to what Kiwi has been saying John. We already pointed out that the numbers you gave for your friend won't make money long term. If you need proof of this type of R:R. Check out don miller's journal which has a fully audit able track record for 2008. You also make the assumption that someone with this style won't improve and lower the R:R inversion and/or better their win%.

 

My best regards,

MK

[jonbig04 10]

Mathematically, yes I see the points. Inverse isn't any different. Practically, though I don't think so. Of all the profitable traders, say here on TL, how many of them have inverse r/r? Of all the profitable traders in the world, I wonder how many have inverse r/r. I'm sure some do. In theory it seems to be able to work, in practice though, with leverage, emotions and plain old good bad bad luck around, I doubt its so clear cut.

[Kiwi 16]

Faith vs Reason

Religion vs Science

Opinion vs Evidence

[jonbig04 10]

Haha, well that's a whole different discussion. Anyways, there has to be a reason most successful traders don't use an inverse r/r right? Mathematically you can take it into any extreme you like. Doing it though, day in, and day out may be different...for most traders it seems to be.

[Kiwi 16]

I think you can say "most people who have learned to trade from books and bulletin boards don't use inverse rrs" without risk of being wrong.

 

You could also say that all the buy and holders who bought over the last 5 years aimed to have a rr in the 3+ range (if they ever consciously addressed such things).

 

 

But 50,000,000 flies eat xxxx .... which doesn't mean that following them is the smart thing to do. Survival of the fittest (most adaptable) or survival of the one who does what all the amateurs (and most semi-pros) do? I'm trying to say that its not a different discussion at all. This business is full of "religious" ideas. But the profitable businesses may well be built on ideas scorned by the followers of the trading religions.

 

Your friend may really be on to something. But he does need to understand both his expectancies and also what would cause his strategy to fail ... and whether that is likely / avoidable.

Edited February 6, 2009 by Kiwi

[zdo 20]

Tell your friend

1. to continue to fit the system to his self. Most try to fit themselves to a system or attempt some compromise in between.

2. let him know that the consensus here is that he’s not quite there yet. I think he’s in ‘no man’s land’ and if he’s not willing to do a lot more work and development, he’s doomed. Posted above where imo he needs to get.

3. that inverted high frequency trading will teach him more about staying in synch realtime with the auctions than just about any other way and can accelerate progress on the requisite screen time needed to be adaptive enough to thrive long term.

4. that once he has mastered staying in synch realtime, then he can begin to sensibly leave appropriate size on at his old targets and suddenly realize he’s getting loaded up ahead of the bunches and beating them at getting out too

5. that once he has mastered staying in synch his drop dead stop might remain ~20 ticks but he will be exiting losers way ahead of that.

6. that he’s not normal… that he’s on his own… to expect no short cuts or significant assistance… to put in earplugs and blinders, tighten his equipment and go straight ahead.

[steve46 12]

Over the years I have seen a few traders who have tried to use inverted Risk/Reward in their systematic trading. None of them have been able to make it work consistently over the long run.

 

Using an inverted R/R it tells me that the trader doesn't (yet) have the skills necessary to obtain favorable entry on a consistent basis, and that is a significant problem.

 

Professionals look for entries with specific characteristics. Retail traders simply look for the setup and enter thinking that the odds are in their favor. Problem is that each trade is a random event. That is why even systems with positive expectancy can have extended strings of winners and losers.

 

I hope it is clear how this works. Perhaps your "friend" can learn from this comment before the market teaches it to him the "hard way"....

 

Good luck

 

Steve

[wjrusnak 10]

Well, in the past week I could have made two trades become monsters, but I was stopped out with my small stop. On the other hand I also watched three trades that became disasters, but luckily I was stopped out.

Think about this Jon: your buddy makes $5*6 ticks ($30) per win and wins 80% of the time you say. Lets go with a sample of 100 trades. He makes 80 wins (x $30) = $2400, but loses 20 trades (x $100) = $2000. Net $400 gain.

So, this is better than negative or break-even, but what happens when his calls become poor say 20 times in a row. Now he's down $2000 and his comeback is going to be $30 per win, not guaranteeing that he will win every trade from here on out.

Imagine looking at an excel spreadsheet of your trades seeing win ($30) win ($30) win ($30) loss ($100) win ($30) loss ($100). One step forward, three steps back? If you are a trader that makes great calls and wins 90% of the time, then why even have a huge stop like that? The giant stop is "bad call" forgiveness, but do you really want to be continually rewarded for bad trades when soon enough your bad trades will kill your account?

In conclusion: is he trading or is he gambling?

[jonbig04 10]

Thats my opinion too, his large stops make his accuracy possible, just like my large reward makes my inaccuracy profitable. But equating a large stop loss with holding on to your winners seems strange to me.

[diablo272 10]

It might be time for you to take an evidence based look at it.

 

Look at his system. Analyze his results. Recheck with Monte Carlo.

 

You might well find that his risk of ruin is considerably lower than yours for a give risk percentage per trade. Perhaps with his high win rate and the resulting reduction in probability of a sequence of losing trades he can thus risk more per trade for the same risk of ruin.

 

Evidence not faith leads to better business decisions.

 

This is slightly off topic, but you mentioned Monte Carlo here, and I'm curious as to how you would apply Monte Carlo to this situation. I'm very new to this kind of risk modeling, so this is probably a stupid question, but if his friend has a stop of 20 ticks and a target of 6 ticks (assuming these are hard stops and targets), where would Monte Carlo come in? Would you use it to calculate something like max drawdown? It seems to me there would need to be another variable in there, because the stop and target are both absolute. Again, I'm completely new to Monte Carlo and all but the most basic risk modeling, so bear with me.

 

EDIT: I should also mention that I'm terrible at math, so something that may seem obvious to someone who is proficient in math will probably be obscure to me.

Edited February 7, 2009 by diablo272

[sneo 10]

from where i see, monte carlo is probably used in randomly generating a series of winners/losers, upon which we apply the points gained or lost. then sum up the values to see if it works in the long run.

 

it is not impossible for a negative risk/reward to work if:

1. there is sufficient capital to hold a losing position (perhaps in this case -19pt max) for it to go to a positive region.

2. the product traded has low volatility, and the setup has to have a damn good entry point.

3. sticking to the rules like a robot.

[jficquette 10]

It doesn't have anything to do with negative or positive risk reward. It has everything to do with positive expectancy.

 

Assuming 3.33:1 and 80% ...going off of 30 trades...

 

Wins: +24pts (24*1)

Losses: -20ts (6*3.33)

Profit = +4pts (appx)

 

But like MidKnight said, your commissions would have to be less than $0.67/rt to make money in this simple example.

 

However, there is still one piece of the puzzle missing. Commission only comes into play per transaction. So if his strategy was going for much larger swings, then it could be profitable strictly by the numbers.

 

 

I agree. Its doesn't matter how much you risk. All it matters is how much you win.

 

It has everything to do with positive expectancy.

 

John