Apr 01 2008
Can You Explain The Formula Used For Determining Opportunity Etc A Little Better?
I’ve been asked by visitors to explain more clearly the formulas used for determining opportunities required based on a system performance metrics and the objectives set by the trader.
We include 2 tools in our Pentagonal Trading program that take care of all of this, one of them being the Trade Performance Analyzer by Brian McAboy.
However, I’m going to give you a step by step process for doing this based on you having certain information already. I’ve also included a formula chart or worksheet you can follow to help you understand the process a little better.
What you need is some results of your systems performance either through back-testing, paper trading or live trading or a combination, and the following:
1. The average net profit per trade over all of you trades
2. The number of days in a trade on average (include all days not just trading days)
3. The largest position size or use of capital (the margin required for a trade)
4. The biggest drawdown
5. Your objectives be they yearly or monthly goals etc
6. Your trading capital
7. Your drawdown limit (how much of your capital are you willing to lose)
If you don’t know how to determine your average net profit per trade then do the following: get you overall NET profit from all trades, and divide this number by the total number of trades taken, including losing trades. So if you had 40 winners totaling $25,000 and 60 losers totaling $15,000, your NET profit is $10,000 (25,000 – 15,000), which you then divide by 100 (number of total trades taken), to give you an average net profit per trade of $100 (10,000 / 100).
The average number of days in a trade is to just add up all the trades’ lengths in days and divide by the number of total trades taken.
The largest use of your capital per trade is the position size (if trading stocks or options), or the margin required of you if trading stocks on margin or CFD’s, Forex or Futures.
The biggest drawdown is the largest fall of your equity in currency terms relative to your starting capital (assuming no compounding for ease of calculations) at any time throughout the trading period. You should also determine the longest losing streak in number of losing trades in a row.
I’m going to assume some numbers to make this easier. I’m going to assume the trader has a goal to make $30,000 over the next 12 months. I’m also going to assume the following.
1. Average net profit per trade is $150
2. Average number of days in a trade is 21
3. The largest position size (or use of capital/margin required) is $3000
4. The biggest drawdown is $5000 which occurred over 8 losing trades in a row
5. Trading capital is $50,000
6. Drawdown limit is 25% or $12,500
This trader wants to make 60% in the next 12 months but is only willing to risk 25% in order to do it. Let’s see how he goes.
1. We first divide the goal, which is $30,000 by the average net profit per trade which is $150. This gives us the number 200 (30,000 / 150). What this number is telling us is that this trader will need to make 200 trades over the next 12 months to reach his goal. The reason is because this trader already knows his average net profit per trade.
2. Next we multiply the number of trades needed which is 200 by the average length of each trade which in this case is 21 days, giving us a total of 4200. So if the average length of a trade is 21 days, and we take 200 trades we will need a total of 4200 days of market exposure, but we only have 12 months. So we divide 4200 by 365 (# of days in a year) which gives us 11.5, rounded up to the next round number giving us 12. This tells us that in order to make 200 trades in only one year we will need to have the ability to have 12 trades open on any given day because in all likelihood we will. The only way to produce 200 trades in a year is to have multiple trades open at once.
3. Then we must multiply 12 by our largest position size (or use of capital) and in this case it’s $3,000, giving us $36,000. Because our starting capital is $50,000, we can safely have 12 trades open, in fact we can have even more, but 12 is all we need so that is fine, plus $3000 is the largest use of our capital and not our average, so the figures are conservative.
4. Now comes the tricky part and that is the drawdown. Unless this trader is able to simulate the trading of 200 trades in a 12 month period, the drawdown he currently has is only based on a smaller amount of data, and so because of this it is wise to consider worst case scenarios. Our largest drawdown is $5,000 over 8 losing trades. Let’s assume that we have 12 losing trades in a row (I use 12 because this is the number we came up with in point 2 to determine number of open trades on any given day); this gives us a $7500 drawdown (5000 / 8 = 625 * 12 = 7500). This is just using the average loss per trade during that drawdown period; however you could determine the average loss per losing trade from your own performance results. This is well within this trader’s limit, but what if he had 12 losing streaks in a row (based on trading 12 different markets or sectors), this would wipe him out. The other way to look at it is that this trader is only willing to risk 25% or $12,500, and based on the average I used of $625, he can tolerate a 20 trade losing streak (12,500 / 625). This trader will have to ensure he diversifies his market exposure so as not to rely too heavily on one or two sectors or asset classes.
So it seems that this trader can operate his system fine as long as he does not have any more than a 20 trade losing streak, as this will take him over his drawdown limit. This means this trader will need to know a bit about the various markets he plans on trading and how he is going to find 200 trading opportunities across a diverse market place (i.e. trading many sectors/ asset classes/ mixing longs with shorts and so on) in a 12 month period. Of course the trader can adjust his goals, he can adjust his drawdown limit, he can try and adjust his system to try and improve its overall performance both in average net profit per trade and a smaller drawdown.
I’ve added a formula chart or worksheet you can follow to help you understand the process a little better.
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[...] Investing Blog wrote an interesting post today onHere’s a quick excerpt I’ve been asked by visitors to explain more clearly the formulas used for determining opportunities required based on a system performance metrics and the objectives set by the trader. We include 2 tools in our Pentagonal Trading program that take care of all of this, one of them being the Trade Performance Analyzer by Brian McAboy. However, I’m going to give you a step by step process for doing this based on you having certain information already. I’ve also included a formula chart or worksh [...]
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Tim Ramsey
[...] Indian Stock Market, Trading Calls, Intra Day - wrote an interesting post today onHere’s a quick excerpt I’ve been asked by visitors to explain more clearly the formulas used for determining opportunities required based on a system performance metrics and the objectives set by the trader. We include 2 tools in our Pentagonal Trading program that take care of all of this, one of them being the Trade Performance Analyzer by Brian McAboy. However, I’m going to give you a step by step process for doing this based on you having certain information already. I’ve also included a formula chart or worksh [...]