of a method even though we have strictly limited the size of the potential
losses. A typical trend following system, which I prefer, will only make
money on about 45 percent of trades but the winning trades will be about
2.5 times the size of the average loss. Let’s assume, for simplicity sake, that
each loser is $1 and each winner is $2.50. That means that you should have
a profit of $57 (45 times $2.50 minus 55 times $1.00) after 100 trades.
Reducing the number of losing trades by 10, or about 20 percent, improves
the profitability dramatically. The percent of the 100 trades that are
now winners increases to 55 and the number of losing trades drops to 45.
Now the profit is $92.50 (55 times $2.50 minus 45 times $1.00). That is a
dramatic increase in profit of 62 percent! A small change in the ratio of winners
to losers can create a dramatic change in the profitability of a method.
This suggests that we must be always searching for ways to decrease the
number of losers compared to the number of winners in order to boost
profitability.
Note that the rejection rule and last bar method increase the number of
losing trades significantly but the total dollars lost declines. We have substituted
a larger number of small losses instead of a fewer number of large
losses (or kept the size of the losers constant but dramatically boosted the
size of our winners). These changes sharply enhance our profits.
It is profitable for you to keep track of these kinds of statistics for your
own trading. Then you can concentrate on fixing that part of the equation
that you really need to work on. Is it cutting losses? Increasing the size of
your winners?
I mainly focus on eliminating losses or minimizing the size of losses.
The reason is that this enhances my psychological ability to trade. I’ll talk
more about that in a later chapter but let me mention a few things here.
One of the most difficult things for traders to do is to suffer through a
string of losses. Most people will stop trading a method if they have three
losing trades in a row. They will say that the system is flawed or they are
flawed and stop trading. So it is particularly important to attack the inevitable
losses that come with trading. Reducing losses in a method by
several a year could mean the difference between my psychologically continuing
to trade, or stopping.
Psychologically, a small or miniscule loss may be the same as no loss
so it is also important for me to strive to reduce the size of losses. My goal
is always to reduce the size of my losses to a level that I won’t remember
tomorrow if I had a loss today. I am not likely to have any psychological
bad effects from a trade that I can’t remember!
Source:How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
