We have discussed about different type of trading system,Once you are able to decide what type of system suits you next is important points to include as part of your trading system.
1) Positive Risk To Reward Ratio
Risk to reward ratio is something that you need to understand when it comes to creating your trading system. With out a good risk to reward ratio you are fighting a losing battle. This factor will make the difference between a system being a winner and a loser. A risk-reward ratio is how much you expect to make on a trade, relative to how much you’re willing to lose.
The risk/reward ratio marks the prospective reward an traders can earn, for every rupee he or she risks on his trades.
Assume, based on your analysis or trading strategy stock reliance trading at 1600 will reach 1640 at which point you will take profit, resulting in a Rs 40 gain. And you are willing to risk 1580 as stoploss i.e 20 pts.
Your potential reward is therefore twice as large as your potential risk. ie 40/20 2:1
2) A Good Strike Rate
- A low Strike Rate, 50% or below, requires winners to be larger than losers in order for you to be profitable •
- A Higher win-rate > 70 or 80% with lower risk-reward ratio usually has negative expectancy. Means Strategy losses in the long run even with higher win rate. • Eg : Naked Option Selling. Selling Deep Out of the money options (Extremely higher win rate but poor risk reward ratio)
Obviously this is quite logical but the more winners you have the better. But it must be taken into context with the risk to reward ratio though. Also, don’t forget to take into account break even trades when working out the rate. You can do this in several ways.
You can just ignore all break even trades (but remember to remove them from the number of trades taken number) or you can include them as a loss as they are definitely not to be considered a winning trade.
Imagine any of the sophisticated professions you know, they all require a high level of skill and years of training and practice. Pilots and Doctors, especially surgeons, know how high-risk and dangerous their work is. Its proficiency is usually placed on proper training and continuous practice. To an outsider, their job is extremely difficult if not impossible, but due to years of training and consistent practice, they have been able to master it so well it almost seems effortless. Consistency can never be overrated. It is the soul of perfection and progress.
Aristotle once said, “We are what we repeatedly do. Excellence, then, is not an act, but a habit.”
You need your trading results to be consistent. You should be able to visually see if a trading system is consistent. It will never be perfect and you will have a bad day in week or a bad month or two in a year period. But what you do not want to see if that all your winners at the start of the test period and all your losses at the end. This would mean the system has been ‘curve fitted’ (whether intentional or unintentional).
4) A Good Profit Factor Value
Profit factor is the profit generated by all the profitable trades divided by the losses generated by all the losing trades. This is similar to the risk to reward ratio but instead of using the the number of trades generated you are using the value of those generate trades. The benefit of this calculation is that it takes in to account strike rate where as risk/reward is just an absolute value.
A trading system could have a 1:1.5 risk/reward ratio but a profit factor of 2.25 meaning that the system over a period made 2.25 times the value of the losses in profit. Obviously the bigger the value the better.
I would probably use risk to reward when devising a system and profit factor when analysing trade history. But as usual it needs to be taken into context. Profit factor needs to view alongside number of winners and number of losers.
There are plenty of scam systems that have fantastic profit factor but that is because out of 100 trades it only made 2 losses (probably because it just kept adding to a losing trade until it became profitable). This is an issue which brings me on to my 5th item you need for a profitable trading system.
Obviously there are plenty of other system measurements but I believe the above 4 will tell you whether you have a winning system or not. Everything else is all subjective on whether you want more profit and at what level of risk.