You have probably seen it before. You picked up a glossy brochure or saw an impressive newspaper advertisement claiming an “accurate” trading system that gives a success rate exceeding 80% or even 90%. Sounds attractive, doesn’t it? What if it is true? Imagine how much money you can generate if you are able to consistently pick the “right” trades in the markets.
Here lies the truth about such claims and contrary to the earlier assumption, that “highly accurate” trading system can in fact cause you to lose money!
Everyone is always searching for that “holy grail”, the one system that does it all. That “perfect” system that will help you pick a stock at the lowest price before it shoots up and help you exit at the highest price to maximize your profits. The system that will consistently help you pick the top of the tops and bottom of the bottoms. The truth is that if anyone is telling you or selling you this, you will do well to heed that instinctive “warning bell” that goes off in your head.
In fact, the more accurate your trading system, the lesser your chance of being profitable! How is this so?
Firstly, we have to realize what it means to have an “accurate” trading system. To make this claim such as 80-90% accurate means that the trading system has to be right 80-90% of the time. Is this possible? Sure, it is possible but to be right so frequently means that the average you can make from each of the winning trade will normally be low to keep that ratio high. Traders will be encouraged to take quick profits before it disappears.
Here is an illustration.
Say you have a trading system, Trading System T, that has 80% winning trades, where the average winning trades is $100, and 20% losing trades, where the average losing trades is $1000.
Expectancy, a statistical concept, tells us how much a trader can expect to make on the average of each trade. Expectancy is defined by the formula :
Expectancy = (% of Wins x Average Win Size) minus
(% of Losses x Average Loss Size)
Therefore in our example,
Expectancy of the Trading System T = (0.8 x $100) – (0.2 x $1000) = -$120
The expectation is actually negative. That means a trading system that is right 80 percent of the time can lose you money.
On the other hand, a trading system that has a positive expectancy could lose 80% of the time and still be profitable. Let’s call it Trading System S. Using the same numbers:
Expectancy of Trading System S = (0.2 x $1000) – (0.8 x $100) = $120
The above examples show how and why the desire to be right kills many traders. We are conditioned by our culture and environment to be right. Our society does not reward being wrong.
A trader with an inflated ego will always want to be right and thus will try all means to avoid losses. He tends not to take small losses and those small losses turn into big losses which he is eventually forced to take. Most traders and investors focus mainly on accuracy or reliability of a trading system to the exclusion of other considerations. It is no wonder that most inexperienced traders and investors lose money.
The obsession with a high-probability system sabotages a trader in a few ways. First, wanting to be right causes the trader to be less flexible when market condition changes. Second, it further reinforces the bad habit of not taking small losses when the trade goes against him. Ego plays no part in the market. Third, a high-probability system gives traders a false sense of security that his trades are doing just fine, which in fact may warrant him to take remedial action.
Being right and making money are not the same thing. People have a bias wanting to be right. As a result they tend to gravitate towards a high-probability trading system. Such trading system typically encourages traders to take quick profit in order to achieve high accuracy. This is done at the expense of profitability, which leads to negative expectancy.
The focus of a successful trading system should be on expectancy. With a positive expectancy trading system and coupled with good money management and proper position sizing, traders will at least stand a chance to beat the market. Successful traders are successful not because they predict the prices well but because the size of their profitable trades far exceed the size of their losses.
The next time, someone tells you that his system is 80 or even 90% accurate, be very wary, the system will likely cause you to lose money!
“It’s not whether you’re right or wrong that’s important, but how much money you make when
you are right and how much you lose when you are wrong”
This is the crux of making money in the financial markets.