Essay: Trading system probability
This guide is intended to be a guide for traders concerned with existing trading systems or traders who want to evaluate their own trading systems. I hope you found this valuable. I have been using this information for the past two years and I have found it very useful. <o></o>
Need for system statistics <o></o>
When talking about trading systems, there is a fundamental need to represent their performance in a comparable way. Traders must be able to evaluate a trading system to determine whether the system (a) produces acceptable returns and (b) has an acceptable risk threshold. It is possible to have a highly profitable trading system but put 100% of your capital at risk. Fortunately for us, there are some very useful statistical formulas that summarize this information for us quite nicely. These formulas are flexible enough to be able to compare two trading systems with very different characteristics so we can make an informed decision about both systems. In this article, I will guide us in analyzing Firebird EA as it has become very popular recently. In this example, I will focus on the EUR/USD currency pair because this EA uses different settings for different currencies. <o></o> Basic profitability is the first attribute we will discuss. <o></o>
Risk and Reward <o></o>
The first two elements in calculating expected returns are assessing risk and reward. Most simply, the reward is the mean magnitude of the probability of winning, and the risk is the mean magnitude of the loss. The rates for these events are discussed separately. These usually correspond to take profit (t/p) and stop loss (s/l) for each trade. If t/p and s/l are different for each trade, the t/p values must be averaged over all completed trades (the same goes for stop losses). Some automated Expert Advisors (EAs) in MT4 have encoded fixed t/p and s/l levels, so these values may be easy to find. It is useful to think of these two values as a ratio; a risk/reward ratio. Low risk/reward trading systems are not bad. On their own, they just require some special attention (covered later in the next section). It should also be obvious that the greater the number of transactions used to calculate these averages, the more accurate the averages will be. Taking only 3 or 4 trades using the system will not give very representative numbers, so every effort should be made to take or simulate more trades. For systems that can be backtested, whether in MT4 or elsewhere, if the t/p and s/l values in the system are not constant, averaging as calculated above will give us the results we want. <o></o> <o></o>
Calculating the risk/reward for Firebird is easy. Fixed t/p level is 22 and s/l is 220. The risk/reward is 10/1 and worthy of review. On the surface, this number seems very low. Can a system with this risk/reward ratio be profitable? The following analysis will tell us the exact information. <o></o>
<o> </o>
Need for system statistics <o></o>
When talking about trading systems, there is a fundamental need to represent their performance in a comparable way. Traders must be able to evaluate a trading system to determine whether the system (a) produces acceptable returns and (b) has an acceptable risk threshold. It is possible to have a highly profitable trading system but put 100% of your capital at risk. Fortunately for us, there are some very useful statistical formulas that summarize this information for us quite nicely. These formulas are flexible enough to be able to compare two trading systems with very different characteristics so we can make an informed decision about both systems. In this article, I will guide us in analyzing Firebird EA as it has become very popular recently. In this example, I will focus on the EUR/USD currency pair because this EA uses different settings for different currencies. <o></o> Basic profitability is the first attribute we will discuss. <o></o>
Risk and Reward <o></o>
The first two elements in calculating expected returns are assessing risk and reward. Most simply, the reward is the mean magnitude of the probability of winning, and the risk is the mean magnitude of the loss. The rates for these events are discussed separately. These usually correspond to take profit (t/p) and stop loss (s/l) for each trade. If t/p and s/l are different for each trade, the t/p values must be averaged over all completed trades (the same goes for stop losses). Some automated Expert Advisors (EAs) in MT4 have encoded fixed t/p and s/l levels, so these values may be easy to find. It is useful to think of these two values as a ratio; a risk/reward ratio. Low risk/reward trading systems are not bad. On their own, they just require some special attention (covered later in the next section). It should also be obvious that the greater the number of transactions used to calculate these averages, the more accurate the averages will be. Taking only 3 or 4 trades using the system will not give very representative numbers, so every effort should be made to take or simulate more trades. For systems that can be backtested, whether in MT4 or elsewhere, if the t/p and s/l values in the system are not constant, averaging as calculated above will give us the results we want. <o></o> <o></o>
Calculating the risk/reward for Firebird is easy. Fixed t/p level is 22 and s/l is 220. The risk/reward is 10/1 and worthy of review. On the surface, this number seems very low. Can a system with this risk/reward ratio be profitable? The following analysis will tell us the exact information. <o></o>
<o> </o>
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