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Depending on the type of system you are trading, you will have to set the range of values. A trend following system may have good results between the 40 percent to 60 percent range, whereas a short-term oscillator system may range higher: 60 percent to 75 percent. The higher the risk-to-return ratio, the less you have to be correct to make a profit. Traders should always make sure that their trading has a good percent profitable for the system that they are trading and should be very cautious when this number decreases too rapidly. This may signal a change in. the market, trending to sideways, or a system that is no longer working due to some variable.

The same chart can apply to percent losing trades as well. Figure 7.9 shows a percentage profitable chart. Notice how the percentage has stayed mostly within a range of 50-70. In this case it may be advisable to raise position size above 70 and cut size below 50.

Some systems will trade heavier when the percentage is above a certain number. I have a system that made 94 trades. Its ending equity was $51,292. As a modification, I keep a running total of the percentage profitable and double the position size from one to two contracts when the winning percentage is 57 percent or greater and keep only one contract when its below 57 percent. This modified systems final equity is $60,112. What about drawdown since we are trading two positions? Surprisingly, the results are favorable as well. The original systems drawdown was $2,433, while the new system had a drawdown of $3,138. So for an increase in risk of $705 we added $8,820 to our bottom line, not bad! Figure 7.10 shows the two resulting equity lines.



Average Profit and Loss

On a single chart, plot the profit made on each winning trade and on the same chart plot its moving average. Average profit is calculated by taking the total of the most recent N profitable trades and dividing it by N. For example, if the last trade had a profit of $800 and the most recent 10 profitable trades totaled $7,000, plot $800 and the running average $700 ($7,000/10). The profit line should, for the most part, stay on or above the average profit line. One should look to maximize profits on every trade. As you get better, profits should be greater than the average. When profits start falling below the average profit line, one should remain very cautious and reduce position size or halt trading. This again can provide an early warning sign that the markets are changing or that a losing streak is occurring (see Figure 7.11).

This chart can also be calculated for average losses as well. As you get better, the size of your losses should shrink. If your losses are increasing too rapidly, reduce position size or halt trading. You can also apply a moving average on your losses chart. This time, your goal is to have a loss that is less than its average.

Figure 7.10 Running equity of the original and modified systems.



Figure 7.11 Profit per winning trade and its running average.

Risk versus Reward

Reward versus risk and risk versus reward. These terms have been thrown around much in various articles and books but what do they really mean? Reality says that risk versus reward is the cornerstone and foundation on which all else is based.

Risk is the amount of money that is on the line whenever you place a trade. If you do not use stops, then risk is unlimited. Theoretically, the market could fall to a point that would ruin you (e.g., being long the day before the October 1987 crash). If you have a stop in the market your risk is limited to the price of the stop. (This is sometimes not true due to other factors that we will touch upon later.) Risk can also represent the amount of money that you lost when the position is exited (closed).

Reward is the profit that is made from the trade you are in. This only occurs when the position is exited. Paper profits do not count. You could be long from 100 and the market is now at 105, giving you a 5-point profit (reward). But, what happens when the market opens 7 points lower and you exit the position? Your reward has now become your risk. Remember that only real profits and losses matter when you evaluate anything.

When you evaluate a system or trading result, you always have to consider re-» ward relative to risk. This is also called the reward-to-risk ratio. If your systems reward-to-risk ratio is 2:1, it will make $2 for every 1 $ risked. Eventually, you will come out ahead on the long run. Depending on the profitability of the system, your ratio can vary. If your ratio is 3 or 4:1, you can afford to have many more losers than



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