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

MEMO

MONDAY DEC 15 2008 – 1 PM HK/SIN TIME

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TOPIC : Asian Markets (Generic View)

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Hi Ray, 1. WPC and LCC, are they factored into the equation somewhere? 2. Am i correct in assuming your initial stop is at -20% range, or with discretion at -10% of bar of conviction? Your risking approx 30% of the range to get 60-80% +, of the range. So if your stopped out half the time,you would still be 30%+ up. 3. volume calculations and strength rating,is this the same as the quick n dirty way with similar ratios of success or failure to get thru fail zone? cheers Baz

Hi Baz

Thanks for the comments.

I don’t quite get the pictures you are painting.

It’s true that in the 12-M, a conviction bull close above 867 triggers the buy signal. A 12-m stop would be below the Max Extension at 611.

But I am not trading the 12-m; I am trading the 18-d; and, while I would ride the 12-m coat-tails, because I’m trading the 18d, I’d need to find a zone and entry basis the daily chart.

Your process of thought on the reward to risk mirrors my own.

Vol calculations and momentum studies affect my probabilitis of success assessment – is that what you mean?

Sorry, i was trying to paint one picture on the bigger canvas. Yes the vol calculation,i was interested in how you treat them and if you had a rating system like you do for impulse/correction moves in the book and time ratios. I found some markets react at the 50% area almost exactly while others its more like 61% my theory was maybe to do with more retail traders react at 50 but institutions a later figure,its just my theory i cant prove it. I have found monitoring vol on the minute chart at fib levels for the first signs of when big players enter,helpful too. This may seem an odd question but do you think the market profile maybe better suited to helping exit positions than entry? My thinking here is that your maximising the range potential.Maybe a nuance? just thinking aloud. cheers thankyou baz

Hi Baz

In using price and vol, I just apply the Wyckoff principles. In a way, I use them about the same way Tim Ord, in The Secret Science of Price and Volume,uses them; but unlike him, I do not use numerical ratings.

I agree that some markets react off the 50% – e.g. gold while others off the 33% or 67% (ES). I don’t know why.

I don’t agree with your observations about Mkt Profile FOR ME. It may well be true for you. In my case, Profile Theory augments Wyckoff and I find them a great fit and useful for both entry and exit.

Hi Ray,

I understand your rationale of looking at average volume per bar of a possible rally in determining whether the 12M line direction is going to change at the “Failure zone” or continues towards the PSZ.

However, I am unable to figure out how you dervive the average volume of 931,236 & 1,724,603. I tried using mean volume – 0.5/+1.5 volume std dev, but could yield the results. Could you kindly enlighten me?

Many thanks!

Hi Rick

You are on the right track – I use -0.5/+1.0. But instead of the daily reported volume, I use normalized volume.

Thanks Ray, I have truly benefitted from your unselfish sharing on this blog!