Breaking down some numbers today it's become abundantly clear that the metrics I'd like to achieve and what I've accomplished are night and day. This is a principled example of cognitive dissonance and the resolution to this is not 100% clear, so I thought it in my best interest to externalize the conundrum in an attempt of ascertaining coherence.
Ideally my benchmark to achieve is a risk/reward ratio of 3-1. This number is not something I've simply pulled out of my ass --it is completely rationale and here is why; Cognitively it has been shown that the human brain reacts approximately 2.5x more to losses than gains which means that for each loss the gains to balance the internal state should be 2.5 or more. Given this, my thoughts were that if I could maintain this ratio the internal balance of my mental state would be more harmonious and would lessen the discomforts I have at times being in a trade.
The problem is that I've latched onto this anchor and continue to hold to this metric as a goal to achieve while in turn completely neglecting the information my trades are telling me. Here in lies the crux of the problem; what I'd like to achieve I have thus far been unable to do with consistency. In turn I have ignored the profits achieved consistently resulting in sub-par performance. The result is that this has done anything but appease my internal state and in fact it has simply increased frustration and exasperation.
Currently what I have shown myself capable of is a 58% success rate with an average of 1.17 R/R. I have not shown I am capable under the current market conditions to extract 3-1, let alone 2-1 with consistency so it is to my detriment to hold onto this view any longer. In fact, given that my time frame is 5 days I can simply take the max high over this time compared to entry and note that the average has only been 4.8% to begin with. Couple this with my current average profit extraction of 3.93% and I'm really not missing much profit and in fact causing detriment to my productivity in attempting to extract more.
Given this I can only come to the conclusion that it is time to stop fighting the reality of the situation and to accept fully what my personal performance is indicating to me. Which in turn means I will have to modify my plan for the time being. This isn't to say that I'll completely give up on reaching for 2.5+ R/R, it simply means I'll also have to let my metrics show me when I am capable of that. Once my stats begin to show me I am costing myself by not holding on a little bit longer and maximizing potential profit I'll adapt.
Breaking it all down trading in it's essence is simply a game of numbers and probabilities. Each trade increases our sample size and inches us closer to truths about who we are as traders at any given time. One of my priorities written in my trading plan this year was to become more aware of how my numbers speak to me; and given the number of trades I've taken thus far the outline is starting to become a story and it's time for me to start listening.
In keeping with the theme, here are some key formulas to be aware of for trading:
Risk of Ruin is a gambling concept and an important calculation to understand. This is the ultimate calculation a trading strategy is measured against for if ruin is reached that's it --no mas. While a near 0 risk of ruin is not a guarantee that one will not blow up their account, it is important to be aware of as an indication of how well one is trading. If this number begins to increase somewhat significantly it is a good clue that one is not in cadence with the market or that ones strategy is not currently working or worse, one is not trading well at all regardless of the market or the method.
There are two caveats to consider in this calculation. The first being that it requires gains to be larger than losses. Obviously a 50% success rate where losses are twice as large as gains will lead to ruin but it is also important to acknowledge that trading is not a zero sum game. While it is true for every winner there is a loser, it is also true the house wins. A series of ten flat trades can still burn 1% of an account.
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| Risk of Ruin |
Expected Value is another important concept to understand. If you don't know the expected value of each trade you are doing yourself a disservice. In conjunction with a near zero risk of ruin this is the second factor that must be taken into consideration: a +EV system. Knowing these correlations will greatly assist in understanding the risk that is being taken. If the system is not positive and there is an 8% risk or ruin why is the system being traded at all? If it is marginally positive, where can things be tweaked to improve performance or reduce risk?
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| Expected Value |
If the first two are positive, then the tweaking comes in the form of personal performance statistics. Figure out what stats are important. I trade with a 5 day time stop so I keep track of how the trades I take perform on this time frame whether I get stopped out or exit before then. Additionally what has been critical information for me to know is if the days close is higher than entry and if the second day has a follow through. A secondary piece of information I watch is the max high over the 5 day period which further heightens the discrepancy between what the stocks over my time frame were capable of moving from my personal desires. You're numbers won't lie to you so deducing this information is absolute imperative.
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