Expectancy plays a big roll in trading

[Matt Bowen]

I want to read you this quote to you, but before I do... I want you to read it very slowly and then pause to reflect on it because it's extremely powerful:

"Avoiding mistakes makes people stupid and having to be right makes you obsolete" Robert Kiyosaki

Now the average person is going to read that and go: "so what, that means nothing to me"... if that's your reaction then you are in for a very difficult ride to try and understand this business. Why? Because it's really very simple. When you trade you should never try to avoid the loss because the rules should be in place before you even put the trade on. And if you are still thinking that you need to be right on the majority of your trades, you are still thinking like 95% of the losers in this business... read the report below, this will help fill in the "gaps" of your thinking. The report shows and incredible sample size (22 years and 18,000 trades in all). What's the System, a simple channel breakout ( buy or sell ) X amount of days at a new high or a new low and then use a ATR stop. Here is a recap on ATR stops:

http://www.mtpredictor.com/pricing/documents/ATRStophelpfile.pdf

The following report from a Hedge Fund company called BlackStar. It really highlights the use of expectancy and how it can effect the performance. Notice, the system does not look for profit targets... it simply lets the ATR stop kick-in and take over to manage the trade to completion.

The Report shows proof that trading can be made extremely simple by working ATR stops. It' an excellent report and I hope you enjoy reading it...just click on the e-mail link below:

http://www.blackstarfunds.com/files/Does_trendfollowing_work_on_stocks.pdf

My point here is that the system is not that great, but yet it delivers a very solid performance. The system actually delivers about a .71 R-Multiple and runs a compounded rate of return at 19.3% per year (remember this is a about as good as a random entry method). Take a look at the charts below and look at what happens to $25,000 compounded to 1 million. Next, look at what $25,000 does on just over 41% annually (which can be done by any individual very easily (if) they follow the rules of a half way decent system.

So the question begs, why don't we have many people doing this? I'll tell you why: GOALS.

Because everybody's so jacked-up focusing on the last 30 seconds of the market action and sucking down their 6th cup of coffee by 10:00am. Next, they have CNBC and Bloomberg blasting 10 jackasses who are pumping out the latest brokerage recommendations... None of which has anything to do with their trading a set plan of action. Trust me, all the technology we have today is not making people better traders, in fact, I'm finding the exact opposite is happening... because very few traders have the ability to focus on the their long term goals. Seriously, ask yourself this one question: "What percentage return will you have on December 31, 2007" If you don't have a goal... you are in trouble". It does not matter if you are a day trader or a position trader... you have to be focused on the end result... this is your business!

Studies show that people who set goals achieve more in life.

[Angel]

Hello Matt, hello all,

First Matt, thanks a lot for your very clear and sincere reply. I really like your simple but effective way of thinking :)

Now let me ask you another question relating on triggers's level :

Considering the fact that a set up is qualified (MPT rules), did you ever think to include volatility (volatility breakout) in your trigger ?

As example for a SELL EOD trade, the trigger would be the low of the RED current bar less the 70% or 80% of the daily ATR(10) because generally, when the market makes a strong ONE-day move in some direction, it's a good sign that this move goes in the same direction.

Thanks,

Have a good trading day all,

Regrds

Angel

[Matt Bowen]

Hi Angel,

Thank you and you are very welcome. Yes, I like Volatility breakouts. In fact, right after Larry Williams won the Robbins World series of trading by taking a $10,000 account and running it up to $1.1 million many people wanted to know how he did it. Well, as it turns out he was using volatility breakouts for the entry (You can read more about them on Steve Notis' website)

http://web.archive.org/web/20021209100412/www.byte-research.com/channel.htm

In any case, like usual, the public went "Ape shit" over these new volatility breakouts and then came a flood of volatility break out systems...and just as the 1990's rolled in (2 or 3 years) later volatility dries up and then everybody is going: what the hell happened...my volatility breakouts don't work anymore?

What the system vendors failed to realize is that Larry Williams success was not because of the Volatility breakouts...it was because he was using a money management called the Kelly formula (something that in the long run will make you go bust because it leads to insane risk/reward levels).


Michael Covel says this about the Kelly Formula:
What is the Kelly criterion (or formula)? It is a formula for calculating how much to bet. It assumes that your objective is long term capital growth (getting rich). The handicapper's choice of money management strategy is similar to the stock market choice between growth stocks and income stocks. Growth stocks tend to be more volatile, but in the long term return more profit. That is because the profits from growth stocks are reinvested rather than skimmed off. Every reinvestment is a calculated risk. Therefore, income stocks tend to fluctuate in value less, but also return less profit in the long term. Kelly betting is for growth. It reinvests profits, and thus puts them at risk. If your objective is to make small but consistent profits,it may be too aggressive a money management scheme.

The Kelly Formula by Ed Seykota

K = W - (1-W)/R

K = Fraction of Capital for Next Trade

W = Historical Win Ratio (Wins/Total Trials)

R = Winning Payoff Rate

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For example, say a coin pays 2:1 with 50-50 chance of heads or tails. Then ...

K = .5 - (1 - .5)/2 = .5 - .25 = .25.

Kelly indicates the optimal fixed-fraction bet is 25%. Now you see why $10,000 can grow to $1.1 million in 12 months.

The Kelly Formula
Note that the values of W and R are long-term average values, so as time goes by, K might change a little.
Reference: http://www.racing.saratoga.ny.us/kelly.pdf (don't try to read the math here it will make your brain hurt and give you a cranium expansion)
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In any case, the bottom line is that the huge profits from Williams system were not related to volatility breakouts, but rather his bet sizing system.

Now, let's address your question of have I used Volatility Breakouts? Yes, In fact some of my first mechanical trading systems were Volatility Breakouts in 1988 and yes I too got caught up in the new craze. However, I quickly learned that volatility breakouts require volatility on a continuous basis or you will chew yourself to pieces with commissions and slippage. In other words, if the markets go flat your screwed because you need volatility to profit. Nothing is worse for a trader using volatility breakouts than to find his market is shrinking in the distance between highs and lows.

Regardless of what type of trading approach you are using , you system is going to work much better in a market that is prone to moving in a strong vertical direction (i.e., more volatility) than a market that is moving sideways.

So, before you plunge into the world of volatility breakouts remember this, they are only the entry of your system...so if you want to use them as part of the entry that is fine...just make sure you check the volatility levels before the entry. Also remember this: Volatility breakouts will go through cycles where they work great (high volatile times) and then dry up when the markets are in (low volatile times).

You might want to incorporate this into your TS1, TS2, TS3 or TS4 setups and do some back testing for all of us here, I would enjoy seeing the results.

All the best,

[Angel]

Matt,

Great, your answer is elaborate and it highlights the most important points :)

So many thanks becoz as usually, you are very helpful and this is one of the best quality of the MTP's team.

Have a good trading day all,

Regrds

Angel

[Matt Bowen]

Thanks Angel.... Glad to help out! :)

[Angel]

Hello Matt, Hello all,

To date, the Decision Point method is delivers the highest expectancy of all MTPredictor setups as well as ANY system I've used to date.I encourage you to be studying this pattern as much as possible.


Please, would you mind to give us some details about the DP's expantcy compared to the TS1, TS2...etc.....?

Thanks,

Regrds

Angel