After my presentation at the Share Investor Expo on December 6, I spent some time speaking about the fallacy of wanting a high win rate. I know that some ‘did not get the point’ – this blog is for you.
The key to investing/trading success lies with the Expectancy Return Formula:
(Avg$Win x Win Rate) – (Avg$Loss x Loss Rate) = Positive result.
The formula makes it clear that the first product MUST be larger than the second. So, how do we do this i.e. in periods of uncertainty? How do we as traders increase our profit potential while limiting the risk?
Figure 1 shows the way.
Entry at the mode zone (two vertical lines labeled RISK) will mean we take a trade when the probability of loss is at its trough and the probability of profit at its zenith. In addition, we take trades when the benchmarks are clearly defined e.g. we can say that if ‘XYZ’ happens we’ll stay in; if ‘ABC’ happens we’ll exit; and we can say that as for the rest, we’ll hold for another day provided we don’t get stopped out.
Figure 1 shows that when we take the trade at the mode of probability of success, our reward:risk ratio is at its optimum.
FIGURE 1: Optimum Profitability
That’s the theoretical picture. To attain this ideal in day-to-day trading, I take a trade when I feel I have 5 items in my favour. As an example let’s have a look at Figure 2, the 12-Month swing (yearly trend) on the S&P
1) The structure of the market: In the S&P, we have a potential 313 Outside Buy Signal (See Figure 1 and The Nature of Trends). I would view such a buy signal as to the left of the Mode of Probability. The context suggests that a failure at the Failure Zone has at least an equal probability of success as the 313 Outside Buy. Unless I could take a buy trade with a relatively low dollar risk i.e. within no more than one ATR 741, I’d bypass the buy trade for the moment.
2) A Price Zone to take a trade
3) The Price/Volume relationship:
The benchmarks I’d use is the average volume per bar as the market rallies to the Failure Zone (the preferred zone is the 66.67% and 50% provided that zone is confirmed by other zone projections):
- If the Avg Volume is at or less than 931,236, then the probability is there will be a Failure. In this case, I’d be looking to sell at the Failure Zone.
- If the Avg Volume is 1,724, 603 or greater, the market will probably reach the Primary Sell Zone at 1553 to 1452. In this case, I’d be willing to buy on a pull back provided the Reward:Risk Ratio is satisfactory.
4) Time: I use statistical estimates to provide a time and price window for the conclusion of a move. I also use some time ratios.
5) Momentum: I’d use Ray’s Clock (see The Nature of Trends)
Once in the trade, I’d use time, structural and price stops to keep the trade within the Optimum Risk Zone (the vertical parallel lines).
FIGURE 2 12-M S&P Cash