The size of profits of a trading system, is related to time and accuracy. They are inter-related and it is not possible to get the best out of all 3 factors in any trading system.
Before I elaborate further, I shall define what these 3 factors mean.
Size of profits – I am referring to the average amount of profits the system will earn per trade.
Time – The average length of time you held on to a trade.
Accuracy – The percentage that the system is correct and earns you a profit.
Big Profits = Long Time = Low Accuracy
For systems that aim for big profits, they must allow a greater range of fluctuations for the trade. By having a large trading range will in turn prevent you from getting stopped out so soon. Hence, you will be in a trade for a longer period of time. Besides having a larger profits, it will also serve you losses that are bigger, because your stop loss limit has to be further from your entry point. It is more difficult to grasp for the relationship with accuracy.
Small Profits = Short Time = High Accuracy
On the contrary, a highly accurate trading system allows you to be right most of the time but each time when you are right, you take very small profits. This is possible by making very tight stops in your trades such that you lock in profits as soon as you make them. Hence, you will be in and out of the trades very fast and frequently. This is typical to intraday trading or mean reversion models or even band trading.
Taking reference from Van Tharp’s book, “Trade Your Way to Financial Freedom“, I shall put forth 2 systems that have the characteristics mentioned above:
Long term trend following method belongs to the big profits, long holding time and low accuracy system. An 80-day channel breakout is a likely signal it will adopt. Profits are expected to be 10-12 times the amount that you are willing to lose. However, such opportunities are rare and the accuracy is about 28%. Which means you will lose most of the time and the trader must be able to manage his emotions during losing streaks and drawdowns on his account.
For highly accurate system with low profits, the system is right at least 60% of the time. A volatility breakout is the likely buy/sell signal. The profit size is expected to be half of your potential lost. Hence, you will need to make enough trades to accumulate a sizable capital. The pitfall to look out for is the costs of trading (brokerage fees and spreads) due to the many transactions that the trader makes.
Therefore, if you want to be a trader, you have to find out your personality – are you one that is eager to wait for big profits once in a while and lose small amounts most of the time? Or are you more emotionally stable to be correct most of the time when you trade but each time you make only a small profit?
I guess most of us belong to be the “Right most of the time” traders but I realized it is not beneficial to be concern about being right. Bill Lipschutz, who was interviewed by Jack Schwager in the book, “The New Market Wizards“, said that “I don’t have a problem letting my profits run, which many traders do. You have to be able to let your profits run. I don’t think you can consistently be a winning trader if you’re banking on being right more than 50 percent of the time. You have to figure out how to make money being right only 20 to 30 percent of the time.”>>> Warren Buffett's secrets to investing is buying a great company at a fair price. Now you can use this
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