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# Am I missing something?

Discussion in 'Trading' started by Muffhands, Nov 4, 2018.

1. ### Muffhands

I have been trading for multiple years now with mixed success. I have taken the time to educated myself on different strategies and have found trading index options to be the most comfortable market for me. I would consider myself fairly educated on relating (retail) topics with the exception of some of the more complex topics like options pricing models and some topics in financial mathematics. Now, with my limited knowledge of coding and backtesting capabilities I have tried my best to find a system that will yield a positive expectancy over long term. This system has been working for me in the short term, but I imagine it is what I don't know about probabilities and options pricing that will end up biting me in the a**. Im looking for somebody with a high knowledge level of mathematics/probabilities to give me more of a mathematical answer.

So here is my questions; my system in simple terms, uses daily support and resistance levels to find high prob setups, and a favorable risk reward in order to yield a positive expectancy over many trades. So just using a mean reversion strategy for example; after a decline, I might look for a reversion to the mean, and ALWAYS have a risk reward ratio of 1:2. If my stop is \$1 away, my profit target is \$2 away. I do not close my trade until one of those levels are hit (stop or sell limit). The most important part of my strategy, is that once the trade is open, I do not close it manually. Either a stop or profit target is hit, and once it happens I am out.

Using this logic, if I can achieve a prob of success of 50%, over 100 trades I should make 50 x \$2 = \$100, and lose 50 x \$1 = \$50 for a net gain of \$50. Now I know this sounds great to me, but I understand there might be something deeper I am missing, so I am looking for some members with very advanced knowledge of mathematics/probabilities and stock/options pricing to fill me in about what I might be missing. The first thing that comes to mind, is that since my target price is twice as far away as my stop loss, I will have a higher prob of being stopped out more often. BUT, by using moving averages, BB, or other types of support/resistance, I am actually able to predict intra day movements in indices with decent precision.

My question is essentially; Will these predictions be enough to combat the difference in prob of getting stopped out vs prob of hitting profit target? Are stocks and options priced to have a zero expectancy even when using psychological levels of support and resistance, regardless of how well you can predict reversals? Is what I am doing in essence like selling options, where your prob of success might be higher but you will eventually have a zero expectancy? Or does predicting reversals in price action give me an actual EDGE.

Part of me almost thinks of it as scalping, where predicting short term movement seems easier to do, but a few losses end up wiping out your gains for a zero expectancy. But then my risk/reward ratio tells me otherwise. Is anyone able to answer these questions mathematically?

Sorry for the long post.

Last edited: Nov 4, 2018
murray t turtle likes this.

Here is my advise, also in simple terms. Not every set up is equal. If you allocate the same cash/risk/margin etc for every trade, you are missing an important part of risk management which is allocation. You need to have a process to rate your set ups. If you do it right, you will "bet" more on better setups and less on average ones. Your losses from the 50% losers will be lower and the gains will be higher. You will even find that you might avoid "average" setups and your 50%/50% ratio will get better. You will learn to do little to nothing when you do not have the right profit potential.

Good luck!

birdman, VPhantom, trader99 and 2 others like this.
3. ### Muffhands

Thanks for the response! I was hoping to get your attention. Now to clarify, there are some setups where I will risk more to make more, or risk less to make less, but Its always generally a 1:2 risk reward ratio. So for instance, on setups where I am more confident, I might risk 2 dollars to make 4, where as on setups where I am less sure, I might only risk 0.50 to make 1.0 for the same 1:2 ratio.

My question to you is, are you referring to having a higher risk reward ratio of maybe 1:3 or 1:4 on my "better" setups, or are you referring to maintaining the same risk/reward ratio of 1:2 (for example) but just placing largest bets like 2:4 or 4:8. Hope this makes sense.

And what is your opinion about my over all mentality towards building a strategy. As I stated at this point it is hard for me to backtest different strategies with my limited knowledge of coding, but keeping a favorable risk/reward ratio and looking for high prob setups gives me the confidence to stick with the strategy long term even after a losing streak, and that over the long term I will have a positive expectancy. Is predicting intra day price action with decent precision considered an "edge"?

Thanks for taking the time to respond.

I'm not sure what process you use to determine the expectation of profit and if wrong, loss. Or, the likelihood of that occurrence. It needs to be based on past data not a feeling.

In Blackjack terms, a good count provides a higher likelihood of a win, so you bet more. This does not mean you will win with a good count, but the odds are in your favor.

In trading terms, if you have real data from past trades, you can review what worked and what did not and the profit/loss from those set ups. You can see what the real gains were with each set up and the real losses and but some simple math behind it. This does not mean you will win when you did in the past, but it will put the odds in your favor.

Look back, how may times did you think you were going to make a 2% win, when the index did X, and you did? Keep a detailed journal.

Muffhands likes this.
5. ### comagnum

I think nearly all of the seasoned traders suggest having a reward-to-risk of at least 3:1. Traders tend to underestimate how large their gains need to be to pay for the losing trades and still make a profit.

For learning more about the math of trading I don't think you can do any better than learning all you can from reading material authored by Edward Thorp.

Last edited: Nov 4, 2018
Muffhands likes this.
6. ### Muffhands

Essentially I am "assuming" that if the stop loss and profit target were the same distance away (or 1:1 risk/reward), and I picked my trades blindfolded, I would have a 50/50 chance of winning or losing, and a zero expectancy over the long term.

Now, by increasing the distance of my profit target to twice the distance as my stop (or 1:2 risk/reward), now my prob of losing is slightly higher than winning. How much higher? That I am not sure of and unsure of how exactly to calculate it ( I assume the calculation would have to include historical deviations?).

So my hypothesis is : if I am able to predict with decent precision intra movements, I can bring my prob of winning/losing back to 50/50 with a 1:2 risk/reward ratio, and then have a positive expectancy over many trades. I apologize if my terminology and knowledge relating to probabilities is elementary. That is why I am here Do you have any recommendations for running the exact numbers?

7. ### nickynoes

I get the feeling you are a discretionary price action type trader, my advice would be to stop focusing so much on the theoretical/mathematical part of it, and putting more time infront of the screen watching the markets, preferably using a simulator or a paper trading account.

If you enjoy watching charts and trying to predict short term price changes that is a great way to make money, you only have to get profecient at it first. The difficult thing is not to get distracted along the way and devoting time into things that ultimately have little impact on your trading ability.

It's also easier if you focus on one timeframe and one market until you master them.

Muffhands likes this.

No, it does not work that way, as you have no reason to believe one occurrence will happen over another. Let's take a simple example, all theoretical.

I believe (all theoretical), that if I look at all the NASDAQ 100 stocks, that if I set a stop to buy stock to open whenever they hit a new all time high by \$0.10, I will make money more than 50% of the time. I then set my target at up 3% and my stop loss down 1%. (I like the 3:1 ratio better too) What if my expectations were wrong? What if I look back or forward 100 trades, and I got stopped out 90 times and made money 10 times, but only 2 times the 3%?
Without that data, you are just guessing.

comagnum likes this.
9. ### Muffhands

So using my original example : " if the stop loss and profit target were the same distance away (or 1:1 risk/reward), and I picked my trades blindfolded, I would have a 50/50 chance of winning or losing, and a zero expectancy over the long term." would this also be incorrect? Wouldn't you statically have a 50% chance of winning and 50% chance of losing?

And I am still a little unclear on why my statement "by increasing the distance of my profit target to twice the distance as my stop (or 1:2 risk/reward), now my prob of losing is slightly higher than winning." is not correct?

As I stated my knowledge of probabilities and mathematics is limited so I apologize if I am having trouble understanding. When you say I need data, how would you recommend I go about getting adequate data? Do I need to backtest strategies using a backtesting software or R, or is keeping a journal of 100 trades enough "data" to backtest?

I do really appreciate you all taking the time to response.