Understanding Your Statistical Edge
STATISTICAL EDGE
A player's advantage in a game of chance that ensures favorable outcomes over the long run is referred to as a statistical edge. Think about a situation where a coin is rigged so that one side has a 51% chance of dropping heads while the other has a 49% chance. When a player wins, they are paid 1, and when they lose, their opponent is paid 1.
This establishes the rules of a game of chance, such as the likelihood of winning and losing, the reward for winning, and the penalty for losing. We may calculate the expectation using these parameters, which determines whether or not one has a statistical edge.
If the expectation is higher than 0, the player has a statistical advantage that could result in long-term financial success. The player who wins the coin game 51% of the time will make money in the long run because the expectation in this example is 0.02.
The metrics of a trading strategy are similar; the win rate, which measures the likelihood of winning, and the average Reward to Risk Ratio (RRR), which measures the average profit divided by the average loss of your trades, are both used. Consider a system that wins 40% of the time and has an RRR of 2, which means that winning is worth twice as much as losing. In this scenario, you risk 1R on each trade, and out of 100 trades, you win 40 and lose 60.
Your expectancy is then calculated by multiplying the number of winning trades by the reward (2R) and subtracting the number of losing trades by the risk (1R), resulting in a profit of 20R over 100 trades. Therefore, your expectancy is $0.2, meaning that for every 0.1 you risk on a trade, you earn $0.2 on average.
A successful approach, however, will fall short if proper risk management practices are not followed. A trading strategy is a tool, but risk management is what allows you to profit.
WINRATE & LOSES
The chart above displays your chances of having consecutive loses based win rate. As seen in chart above even if your trading method is 60% successful, there is still a 70% risk that you will suffer four consecutive losses. You have a greater than 50% risk of suffering eight consecutive losses if your strategy only succeeds 40% of the time. Knowing these numbers is very important as it helps with your psychology when you find yourself losing a lots of trades and you're questioning your strategy.
IMPROVING YOUR RISK TO REWARD
One way to improve your reward on trades is by using your MAE and MFE metrics to determine stops and take profit.
A trader's stop-loss and take-profit levels can be determined using the metrics MAE (Maximum Adverse Excursion) and MFE (Maximum Favorable Excursion).
No matter whether a trade is profitable or not, MAE calculates the maximum drawdown that can occur from the deal's highest point to its lowest position. However, regardless of whether a transaction is ultimately lucrative or not, MFE evaluates the highest profit a trade can achieve from its entry point.
In the above image we can see MAE calculations on trades. We can see that of all the trades taken the trades that have the best performance (above the blue line) are the trades with the least amount of drawdown. This information can help a trader determine at what point he/she should be closing trades if not running in their direction.
Trading professionals can better understand the behavior of the market and set more sensible stop-loss and take-profit levels by looking at the MAE and MFE of their transactions.
For instance, a trader may want to tighten their stop-loss level to reduce potential losses if they notice that their trades frequently encounter a significant MAE before eventually reaching their take-profit level. On the other hand, if a trader notices that their trades frequently encounter a significant MFE before being ultimately stopped out at a loss, they might want to think about establishing a broader stop-loss level to give their trades more breathing room. Overall, using MAE and MFE can assist traders in better understanding the advantages and disadvantages of their trading strategy and in adjusting their risk management plan accordingly.
A player's advantage in a game of chance that ensures favorable outcomes over the long run is referred to as a statistical edge. Think about a situation where a coin is rigged so that one side has a 51% chance of dropping heads while the other has a 49% chance. When a player wins, they are paid 1, and when they lose, their opponent is paid 1.
This establishes the rules of a game of chance, such as the likelihood of winning and losing, the reward for winning, and the penalty for losing. We may calculate the expectation using these parameters, which determines whether or not one has a statistical edge.
If the expectation is higher than 0, the player has a statistical advantage that could result in long-term financial success. The player who wins the coin game 51% of the time will make money in the long run because the expectation in this example is 0.02.
The metrics of a trading strategy are similar; the win rate, which measures the likelihood of winning, and the average Reward to Risk Ratio (RRR), which measures the average profit divided by the average loss of your trades, are both used. Consider a system that wins 40% of the time and has an RRR of 2, which means that winning is worth twice as much as losing. In this scenario, you risk 1R on each trade, and out of 100 trades, you win 40 and lose 60.
Your expectancy is then calculated by multiplying the number of winning trades by the reward (2R) and subtracting the number of losing trades by the risk (1R), resulting in a profit of 20R over 100 trades. Therefore, your expectancy is $0.2, meaning that for every 0.1 you risk on a trade, you earn $0.2 on average.
A successful approach, however, will fall short if proper risk management practices are not followed. A trading strategy is a tool, but risk management is what allows you to profit.
WINRATE & LOSES
IMPROVING YOUR RISK TO REWARD
One way to improve your reward on trades is by using your MAE and MFE metrics to determine stops and take profit.
A trader's stop-loss and take-profit levels can be determined using the metrics MAE (Maximum Adverse Excursion) and MFE (Maximum Favorable Excursion).
No matter whether a trade is profitable or not, MAE calculates the maximum drawdown that can occur from the deal's highest point to its lowest position. However, regardless of whether a transaction is ultimately lucrative or not, MFE evaluates the highest profit a trade can achieve from its entry point.
Trading professionals can better understand the behavior of the market and set more sensible stop-loss and take-profit levels by looking at the MAE and MFE of their transactions.
For instance, a trader may want to tighten their stop-loss level to reduce potential losses if they notice that their trades frequently encounter a significant MAE before eventually reaching their take-profit level. On the other hand, if a trader notices that their trades frequently encounter a significant MFE before being ultimately stopped out at a loss, they might want to think about establishing a broader stop-loss level to give their trades more breathing room. Overall, using MAE and MFE can assist traders in better understanding the advantages and disadvantages of their trading strategy and in adjusting their risk management plan accordingly.
C Nicholas Downie
