Winning Systems

If you haven’t read the section on position size, I suggest you read it before going any further, since what I’ll discuss in this section builds upon properly estimating the size of your position.

So, you have entered long at 970 and your stop is at 960, or $10 away from the entry point. Let’s call the amount of dollars risked on your position 1R. What sets apart good systems from the bad ones is that the good systems let you make multiples of R (2R, 3R, 4R or more) in case the trade is successful. This way, if your system gives you a winning trade in 40% of the time, but your average win is twice the size of your average loss – you have a positive expectancy system that is good and will make you money. System expectancy is calculated as follows:

E=(Probability of a win) * (Average win) – (Probability of a loss) * (Average loss)

Dr. Van Tharp in his book “Trade your way to financial freedom” gives a very detailed explanation of both position size and expectancy, but in a nutshell the above description of system expectancy should suffice. 

Let’s consider an example.  Imagine a system that generates 80% of losing trades, and the average win is 5R, or five times the average loss. Is this a good system or not? The formula tells us that E=0.2*5-0.8*1=0.2 with a plus sign.  However surprising this might sound, a system that is wrong 8 out of 10 times can still be a good system and make money. 

The system that I have developed and am successfully trading for the last 3 years has a 2/1 win-to-loss ratio, while the probability of a win is about 50%.