Friday, 6 August 2010

Good Questions from the Blog

I received a couple of good questions yesterday that I thought I'd answer before I continue with the multi part post on the gathering and use of statistics.

Nick asked:
Hi EL, Thanks for a great blog! I'm learning a lot.
My question is this - when considering risk/reward, do you think of this in terms of probability or money? e.g. Dalton et. al. suggest a trade should have at least 2 points reward potential to 1 point risk with at least 50/50 chance of success (eg). BUT if you risk say 2 points with a 70% chance of at least 2 points reward (implying 30% chance of 2 point loss), then to my thinking, that is pretty much the same thing - actually better with the law of large numbers playing out. Even with the odds closer to the 1:2 ratio, say 35% loss 65% win with even points, you're still on to a winner until commissions come into play :).
Is this your line of thinking. Sorry if I'm jumping the gun.

Nick, calculating a risk v reward ratio before you have closed a trade assumes that you know how far the trade will go in your favour. Risk/reward described in that way is a myth as, of course, you have no idea how big the reward will be by the time the trade is closed.

Your analysis is half right as far as how I think.

What I do is have a maximum financial loss per trade as a fixed percentage of my account. I then make sure that my first logical scale out point is large enough and has no resistance between that point and my entry. I am more interested in the certainty of the trade (high win rate) than the ratio of my maximum possible loss and the first logical scale out point. I have no problem with a 2 point first logical scale out and a 3 point maximum loss per contract because:
  • I have a high win rate
  • I usually exit before the trade hits my maximum loss point
  • I scale out so my average profit per trade will be higher than my first logical scale out point
Trading is a game of mathematics. My trading structure and methodology has to take into account all these things  to underwrite my consistent profitability.

Then I receives a mail from Todd:
I noticed that in general you do not scale into trades.
Did you have any reasons for this other than the obvious lower average price?
I know of one successful trader that swears by scaling in, but most do not.
Any comments?
Thanks for all your sharing.
Scaling into a trade as it goes in your favour means that you are unsure of the trade. I make my assessment of the trade at the entry and size it accordingly as a 100%, 50% or 25% size in accordance with the trade location and whether I see a possibility of doubling down -typically outside in trades.

Any entries you make in the direction of the trade subsequently are at a worse trade location. Why would you want to do that? I am rather an aggressive entry trader striving to get a good trade location as I know it reduces my risk overall.

The interest rate future, German Bund on Eurex, was where I was trading some of today. There were six nice trades. I was too slow on the range extension break of the ES and missed the trade since there wasn't the usual pullback.

1 comment:

  1. Hi EL, Thanks very much for taking the trouble to reply in such detail. I'm really looking forward to your posts regarding collecting stats from back testing and past trades. Should be interesting....

    Have a good week,