BarroMetrics Views: Risk Management III
I asked Baz the question in yesterday’s blog because most newbies focus on a high win rate. But, to produce a consistent profit, successful traders know that this is only one part of the success equation, the other is the Average Dollar Win/Loss. And this leads me to the final context needed to answer Baz’s question:
Our profitability is governed by:
- Our expectancy return and
- Where we are in the Ebb-Flow Continuum
Our success is measured by expectancy return. In turn our expectancy per trader is derived from the formula:
(Average$Win x WinRate) – (Average$Loss x Loss Rate) = + Result
An implication of the formula is that a high win rate can lead to negative result: because the Avg$Win is too low and/or the Avg$Loss is too high for the Win Rate.
For example, plugging in the numbers below to the formula:
(1.00 x .90) – (100 x . 1) = – $0.10
High Win Rate with a negative expectancy result
Now, the Win Rate is less within our control than the Avg$Win. I see the Win Rate as governed by how well current market conditions suit our trading plan. And how well our plan fits is reflected by the Ebb-Flow Continuum.
There are times when our plan suits market conditions to a ‘T” – under these conditions, we’ll have a high win rate. Everything we do turns as as we expect. We are ‘God’s gift to the trading world’ the flow stage. The Ebb Stage is the reverse: everything we do disappoints our expectations. Our Win Rate plummets.
The successful traders I know have tools to recognise the two stages, plan and position sizing strategies appropriate to the cycle stage.
The reason why so many traders fail is because they fail to recognise or are unaware of Ebb & Flow – they continually blow up in Ebb Phase. This assumes, of course, that they have a plan that has a positive expectancy in the Normal Phase. This is the phase that we usually find ourselves. Win some, lose sum and return a positive expectancy.
We return a positive expectancy because, given our Win Rate, our Avg$Win is greater than our Avg$Loss. This is a function of the robustness of our plan and how well we execute it. The latter is totally within our control.
And this leads me to the elements of a robust trading plan – the answer to Baz’s question.