Wednesday, 6 April 2011

Sacrifice Your Potential

I was having a chat with a student yesterday, addressing his particular requirements. During the conversation we agreed on a solution that I want to share, as it may be of use to many of you.

Not all pictures and setups are created equal. Some are surer than others. I have shared my view that one of the most critical paths to CP must include a high win rate. Not JUST a high win rate, but to include a high win rate in your trader's profile.

There are many ways to achieve a high win rate. One step you can take is to leave your stop loss out of the way and double down if your initial entry was too aggressive. But this approach is not for everyone. We each have different risk tolerances and different funds available in our trading accounts.

So how can a high win rate be more comfortably parlayed into CP?

The solution we discussed with my student was to isolate pictures that gave not only a high win rate but a low Maximum Adverse Excursion (MAE) - trades that don't give you much heat. Trades that provide instant gratification.

Those trades exist and with proper back testing they can be found.

OK, we now have such a picture. The next thing to lock down is how much money you need to make, to begin with, when you go live. Let's say $200 per day. Let's also say that your back testing found that there are usually 10 trades a session that meet your requirements, and they have an all out target of 5 ticks.

Problem is that to achieve maximum profitability, the required stop loss is too large and if you use a tighter stop then you stop yourself out of what should be profitable trades. This is where you must Sacrifice Your Potential.

All you want to achieve in step 1 is $200/day. The solution I offered is to tighten the stop so that you sacrifice these possible winning trades in order to achieve a lower draw down and base the TP on these trades that provide Instant Gratification - No Heat - as long as there are enough of them to provide the magic $200/day. 

Yes, you get stopped out of "good" trades but you meet your goal. So the structuring of your TP ends up with you getting, say, 10 trades of which you stop yourself out of 6 with either a tick profit or loss and make your day on the other 4 trades with again, say, 1 loser and 3 winners. So you convert your high win rate to a low loss rate. Once you have satisfactorily completed this step 1, you have lots of choices- either trading more contracts as finances allow or be prepared to loosen your stops to allow more winners.

Structuring a TP can be more complex than first meets the eye. The starting point must be your goal - a specific goal not necessarily related to a magic earnings number. Reverse engineering your TP to meet your goal is often the way to go. Without the TP aimed at your goal you may achieve the very event that you are so hard trying to avoid - losses.

Today's chart is again the 1 tick range bar of the ES. Outside in trades. I have been working on an outside in scalping system and this is the result. Very cool and I can trade some decent size without sacrificing profitability. I started just testing this with an algo for manual trading but it is fast becoming a sister to Flo in its own right. The key is that the yet unnamed algo enters the trade and has optimised scale outs but I override as I see fit.

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