Designing a profitable trading system is key, but the way that profits and losses vary can have an impact on your long-term success.
In my previous article, I wrote
that, other things being equal, a
trading system with lower volatility
would triumph over a system
with higher volatility. To
prove my point, I gave examples
(and a small spreadsheet model)
wherein a system with half the
volatility of its competitor came
out ahead 70-80% of the time
when given the same sequence
of trading results.
Before we go any further, I should make a point of
definition: Volatility is the variance of returns from the
trades. The greater the dispersion of trading results, the
greater the volatility. That said, the problem with a high-volatility system is that
losses put a trader further in the hole, requiring greater
percentage returns in order to recover. The classic example is
starting with $100 and trying to get to $120, a 20% return. If,
instead, you first lose 20%, you must have a 50% return on
$80 to reach your initial goal of $120 on the next trade.