BarroMetrics Views: Left Brain Thinking IV
Shame on me. For Left Brain III, I got lazy, did a minimum blog, and assumed all would be able to follow my line of thought. Thank goodness for readers like Sorin and Paul – they keep me focused.
For context to this piece, I’ll leave it to you to read Left Brain Thinking and Left Brain Thinking II. Here, I’ll provide a detailed outline to my thinking.
To understand the approach, you need to bear in mind the functions of my Rule of 3:
- The first third exit covers the loss on the remaining two-thirds. It’s function is purely defensive. If your approach is similar to mine, after entry, the trade tends to move in my favour even if subsequently stopped out. The first third seeks to make use of this pattern.
- The second third exit is the core profit. If I am to make money, it will be on the exit of this third.
- The last third, a friend once called, the ‘Blue Sky’ contract. It seeks to capture those moves that are greater than I expect. Often these moves fail to provide a location for safe entry; so, holding the last third removes much of the pressure.
OK, lets’ turn to the series…..
The point I was seeking to make was to illustrate the flaw so prevalent the plans of retail traders (at least among those whom I have coached): they treat their profit target on an all or nothing basis i.e stop out or profit with nothing in between.
This is a fatal flaw – whether you are a discretionary rule-based trader or mechanical trader. If the latter, the omission is a trailing stop rule once the instrument moves into the Expectancy Ratio Profit Zone.
Here I am addressing the discussion Paul and I had. I agree that rule-based traders need to follow their rules; but that does not mean they cannot amend their rules should they see a weakness that needs correction – failing to have a trailing stop in this context would be such a weakness.
I use the Expectancy Ratio profit zone to answer the question: when is there enough profit in a trade to say that we need to protect it: if we take too early, we are failing to let our profits run; if we take too late, we are guilty of allowing a profit turn to a loss or too small a profit.
In Left Brain Thinking II, I referred you to an explanation on the calculation and use of the The Expectancy Ratio. I’ll leave it to you to read the piece before turning to the track records of Traders A &B (Figure 1).
Starting from C1:
- Col C is the current low of the move.
- Col D is the entry
- Col E is the initial stop
- Col F is the stop range (entry – stop)
- Col G is the 2x stop range for the 1st third (not needed in this example).
- Col H is the 1st third exit price (not needed in this example).
- Col I is the trader defined 2nd third profit target exit price.
- Col J is the profit range.
- Col L is the R:R (profit range/stop range)
- Col M is the R:R required by the ExpRatio. We’ll be using this in our assessment of the ‘moat’ for the second third.
- Col N is the ‘moat’ i.e. the number of points from the low that trader has before having to take profits i.e. Trader B has a ‘moat 69’ points from 0.8034, i.e. at .8103, Trader B must take profits or risk losing money long-term even if he exits at a profitable price BUT above .8103.
- Col O is the calculation of the price, in this case, .8103.
- Col R win rate
- Col S loss rate
- Col T Avg $ win and
- Col U Avg $ loss.
- Col ExpReturn (not needed in this example)
- Col X ExpRatio: Notice that both Trader A & B have the same ratio by adjusting the R:R to allow for Trader’s A better win rate.
What Figure 1 tells us is allowing for the win rate and avg $win and avg $loss, both Traders have a 20% edge. Note that for the example, the winrate:lossrate is taken from the Traders’ own statistics.
With that in mind, let’s apply the ExpRatio.
We know that:
- the trade’s R:R is 2.15:1.
- we know that Trader B’s MUST have Reward:Risk is 2:1.
- Subtracting (trade’s R:R) 2.15 – 2:00 (Must Have R:R)= .15 (Moat).
By multiplying the moat to the profit range and adding it to the low of the move, we have the maximum allowable retracement to stay with the R:R of 2:1.
Sorin asked why a R:R 2:1?
For the purposes of the example I have assumed that both traders want a 0.20% edge. After that I just adjusted the Col V inputs until I had the 0.20% edge. I am sure that there is a maths formula that covers the calculation. But, since I don’t know it, I used the trial and error method.
Turning now to Andrea Unger. In reply to Paul’s insight that Andrea does not use stops….I made the comment that other well-known traders. So?
My point is there has to be some quantification of what is ‘near’ enough to our price targets. Once that is defined, we can then create strategies to ensure we take second third profits close to that required by the Expectancy Ratio.
…For those who have done my courses, I remind you that the Rule of 3 is best applied to end-of-day trading. It is less useful when day trading. For day-trading, you are better off using expected range of the day….but that is another story.
…..Finally I posted today because on Monday I want to talk about the S&P.