5 Things You Need For A Winning System

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1) Positive Risk To Reward Ratio

Risk to reward ratio is something that you need to understand when it comes to creating your trading system. With out a good risk to reward ratio you are fighting a losing battle. This factor will make the difference between a system being a winner and a loser.

Simply put if you have a system where you are risking $1 in order to make $2 you have 1:2 ratio. This means you can in effect lose 66% of your trades and still break even. So if you had a 50% winning strike rate then over a basket of 100 trades you will make $50 per dollar risked.

Conversely if you had 2:1 risk to reward ratio you have to win 66% of your trades just to break even. Believe it or not that is quite a strike rate to maintain over a trading career, so you want to make it as easy on yourself as possible.

2) A Good Strike Rate

Obviously this is quite logical but the more winners you have the better. But it must be taken into context with the risk to reward ratio though. Also, don’t forget to take into account break even trades when working out the rate. You can do this in several ways.

You can just ignore all break even trades (but remember to remove them from the number of trades taken number) or you can include them as a loss as they are definitely not to be considered a winning trade.

3) Consistency

You need your trades to be consistent. I know a lot of people talk about maximum drawdown which does make sense but that is only one number. You need to see the spread of the trade results. So I would suggest that you use both maximum drawdown and number of consecutive losses but I would also combine it with manually looking at the results either in a table/list form or as a chart.

You should be able to visually see if a trading system is consistent. It will never be perfect and you will have a bad day in week or a bad month or two in a year period. But what you do not want to see if that all your winners at the start of the test period and all your losses at the end. This would mean the system has been ‘curve fitted’ (whether intentional or unintentional).

4) A Good Profit Factor Value

Profit factor is the profit generated by all the profitable trades divided by the losses generated by all the losing trades. This is similar to the risk to reward ratio but instead of using the the number of trades generated you are using the value of those generate trades. The benefit of this calculation is that it takes in to account strike rate where as risk/reward is just an absolute value.

A trading system could have a 1:1.5 risk/reward ratio but a profit factor of 2.25 meaning that the system over a period made 2.25 times the value of the losses in profit. Obviously the bigger the value the better.

I would probably use risk to reward when devising a system and profit factor when analysing trade history. But as usual it needs to be taken into context. Profit factor needs to view alongside number of winners and number of losers.

There are plenty of scam systems that have fantastic profit factor but that is because out of 100 trades it only made 2 losses (probably because it just kept adding to a losing trade until it became profitable). This is an issue which brings me on to my 5th item you need for a profitable trading system.

5) Know The Number of Winnng/Losing Trades

It is okay knowing what the strike rate is but you need to actually know how many winning trades you have. This is because it will add weight to the first 4 items above. A system that only has 2% losses as mentioned above can only be destined to fail in the long run. But with out knowing the number of losses the profit factor would look excellent when it reality is is misleading. The likelihood in this case would be that the sample of trades is not big enough or more likely, the system has been manipulated to look better than it will be going forward.

Also with some systems the value of losses and winners can vary from trade to trade. With mechanical systems you often get fixed a losses and fixed wins but in other cases a profit factor could not be representative of the system should the losses have been lower in value than normal but winners greater than value than normal. However, this can be corrected by taking a larger data sample this is not always possible and if you unsure of what a “normal” value of a win or loss should be, knowing the number of winners and losers will help you judge validity of the profit factor.

Obviously there are plenty of other system measurements but I believe the above 5 will tell you whether you have a winning system or not. Everything else is all subjective on whether you want more profit and at what level of risk.

2 Responses

  1. Louie says:

    The odds are already stack against you in trading. Doing these five things will definitely put you ahead of the curve in this game.

  2. John says:

    Thank you very much, great trading systems, reading the 5 mentioned nuggets for checking how profitable whatever trading system poeople are using, is not only an eye opening excercise but very important for anyone to diognize and understand why his suppose profitable trading system is losing him some money!
    I did know about the other 4 tips but the point about having to also lok out for a “Good strike rate” was really an eye opener for me.

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