Minimum Expectations Of A Trading Strategy by Wayne Mueller
Fixing Your System
Is your system performing adequately? Here is a method you
can use to determine minimum expected performance.
I have learned that if you are going to trade, you should
trade a system that you have developed using known
parameters in which you have reasonable confidence.
A trading system is a collection of rules and conditions by
which to select, buy, and sell financial instruments. Your
goals, psychology, personality, and capital limits are part of
the mix of influences that ultimately determine the makeup
of the strategies to be implemented. If you are thorough, perceptive, and resourceful enough, you will end up creating
a successful strategy.
Typically, you will backtest your system and come up with a
collection of performance results before you start trading your
system. One form of performance results is a set of R-multiples,
or a distribution, from which a mean R (expectancy or expectation)
and a standard deviation can be derived. R means risk per
trade. For example, if you bought 200 shares of XYZ at $100 and
placed a stop-loss at $95, then R = ($100 - $95) 200 = $1,000.
By keeping R equal to a constant dollar amount or a constant
percentage of equity for each trade, you can keep a good handle on your risk and have an effective method to
track your system’s performance.
From these parameters, I will show how you
can derive a minimum performance curve and
determine the maximum drawdown you can
expect as well as the maximum breakeven trade
number and the terminal wealth relative (TWR) (the retire
point). From that curve and the values described, you can apply
a risk level and enhance profitability by using proportional
bet sizing and Ed Seykota’s “market’s money” concepts (the
difference between current equity and starting equity).
You will want to know the worst-case performance of your
strategy, given a specified confidence level and the minimum
level of performance below which you should consider the
system to be broken. Here, I will propose a method that will
help you make that determination.