Shouldn't the result read out expectancy per year for example? or is it per amount of trades?
Or is it like expectancy in terms of stats like as trades tends to infinity expectancy tends to E(x)?
Dunno if the answers you got made sense to you. I’ll give a long answer where I’ll ramble all over the place and tell you stuff you already know, even though I don’t have the book. Hey, sometimes hearing the same thing in different words helps.
Expectancy is per-trade. So each trade has X expectancy, and that’s how much you’ll expect to make per trade (either in dollars or as a proportion of capital put in), on average. It's then of benefit to have a system that trades often, since that'll make you more money (allowing for expenses).
So if I've got a system with an expectancy of 10% where signals only come along once a year, I can put $10,000 in each year and expect to come out with $11,000 (on average).
If I've got a different system that has an expectancy of 5% that gives signals 100 times per year, I could put $10,000 in each year and come out with more than a million dollars. I could use a million dollars. I have enemies. So the 5% expectancy system kicks the crap out of the 10% one thanks to frequency...
But now we come back to risk of ruin. I'm putting 100% of my money on the line every trade. If that 5% expectancy system wins about 50% of the time (but wins enough compared with losses to get to the 5% expectancy), and I put all my money in every time for 100 trades, the chances that I'll lose all my money is pretty much 100% - I only have to lose once and I’m out. I’d need to flip 100 heads in a row – not going to happen. That is, I've turned a great system into one that will certainly lose everything I have, and my wife will set my testicles on fire.
That is known in the biz as a Bad Outcome.
So you want to maximise how hard you hit a good system, but at the same time make sure you don't get wiped out. Risk 101.
IMO, there are three main considerations. (
These assume you’ve got a system with a positive expectancy. No point worrying about risk if it’s negative. Might as well pile your money up in your yard and light a nice bonfire).
First, the risk everyone needs to worry about is a run of bad trades. In a 50% win system you really have to be able to account for a run of a dozen or more failures. Seriously, spend an hour or two tossing a coin and record the results. It’s edumacational. See how big a run of tails you get in that time. It’ll be big. So say you want to survive a run of 15 failures. And that might be in a period where you got a few more losers than winners anyway. Suddenly you can see why people like to limit themselves to 1-2% risk per trade, tops. Who wants to watch 45% or more of their account ablate defending a perfectly good system? And that’s when you know your system WORKS and has a win rate up at 50%! A lot of very good, profitable systems don’t win anything like 50%. In fact, looking back at wanting high frequency stuff, well, those systems are usually a lot lower than 50%. Which makes the runs of bad luck go even longer.
So estimate your chances, and make sure you don’t risk too much per trade to ride out a slaughter.
The second thing for ROR is maximum position size. If you're like me and hit margin like hobo hits a bottle of cooking-sherry, you need to worry a lot about maximum position size. It's all very well to risk 1% of your capital on a trade, but if you’ve got a tight stop, you might well end up with a “correctly sized” position that’s bigger than your account.
Example: ABC trades at $20, and I can put a valid stop at $19.95 – SWEET, a 5 cent stop! I rule.
1% of my $20,000 account risked = $200 risk.
$200 divided by 5 cents risked per share = 4000 shares.
4000 shares * $20 = $80,000!
Now I can afford that with my $20,000 account, thanks to margin, and it conforms to my other rules, only 1% risk, so in I go! Nice and safe. But hang on – if ABC goes into a halt tomorrow, uh, what then? And if it comes back on the market at $10 after a crushing announcement, or doesn’t come back on at all, I’ve just lost more than my entire account. I’m losing my house. I’m sourcing burn cream. All for a trade that officially only risked $200.
What are the chances? If you do this trading thing long enough, eventually you’ll be holding the bag when something like this happens. You HAVE to be in this for the long haul – this WILL happen some day. Bank on that. And it might be your next trade. So this is where a lot of people put a limit of, say, 20% or 12.5% of total account size in any one position. Not knowing your formula, I’m guessing that’s where you got that number, since it’s a number that makes sense.
Third thing is diversity, or the total of related positions. I’ve got 1% risk per position, and less than 12.5% of total account on any one position, so I’m safe. But I’m holding 10 iron ore producers. Uh, hang on. Aren’t they going to be related? Yeah. In a lot of ways you have one enormous trade with 10% risk and 100% of your account size. So when news breaks of a new mining tax, or civil war breaks out in China, and the price of iron ore tanks, so does your account. You could be looking at a gap that, even without margin, murders you on the open.
Well the same sort of thing goes for different scales. At its broadest, look at long vs short. You may have your holdings well diversified, but if it’s all long and a plane hits a building, you’re still going to get hammered. Again, it’s an issue for everyone, but much more important for the highly leveraged. If I’m fully leveraged at 10 to 1, all long, and the markets drops 10% on the open, I’m bust. And if that seems unlikely, again, remember you’re playing for the long run.
Anything that can happen,
will. Bank on it.
So don’t commit to one thing so heavily that it can kill you. Most simply, you could avoid margin and, further, keep a large part of your account in cash. More complex, perhaps more profitable, is to hedge – best done (IMO) by finding genuinely (if marginally) profitable trades to take that will also respond to a black swan event favourably (eg going short in a weaker, but related stock to one you already hold long). Could be you’ve got a great system that only works on mining stocks and only goes long. Ok, then see if you can afford to take out some insurance by shorting the index – run the numbers, see what you can afford. If you’re picking the standout stocks, could be you’ll still be profitable with a partial hedge, and you may save yourself from ruin some day.
You don't need to be too paranoid about diversity, IMO - just keep an eye on it, hedge profitably where you can, and only do more than that when you're too heavily invested in one direction (particularly if heavily leveraged, and paying particular attention to total long vs total short).
All three factors here effect your risk of ruin.
Sum up:
Risk per trade: covers you against a string of losses, to be expected in any system. You should go into a trade knowing where an appropriate stop is, and use risk to
size the position for you.
Position size: covers you against a single share or instrument suffering a catastrophic move. This imposes a limit on the
size of individual positions.
Diversity: covers you against a black swan event. This imposes a limit on
what kind of positions you can take.
Does that help?
Disclosure: I don't actually know anything.