Determining Risk

twinchell, this is a very informative thread, I searched for the market analysis software and it looks really good, that is going to save me a lot of time, keep the good work, we need more threads like this on this forum!

Twinchell, the teacher always learns the most. When you take the time to research and share information you are the primay benefactor of the knowledge you share. If others learn from your work it is certainly good and to their advantage but certainly not necessary to ensure your continued success.

By the way...nice post jerk!

Just wanted to say thanks for this excellent thread. This is truly a thread that is a "signal in the noise". After coming across it and then researching further with the "Fools of randomness" mention, I read the book and that has been invaluable.

Cheers

A couple of requests have been made of me to provide some info regarding risk / success statistics equations, etc. Although I believe the software referred by twinchell provides all that I would need in this area here are some equations:

the first example came from another source someone provided and I have included a couple of others below. The formula for estimating the maximum losses in a row is:

S = ln(1/T)/ln(L) where:
L = % losers
S = Streak
T = # trades you plan to make
Ex.
T = 10000 trades in your trading career
L = .1 or 10% losers
S = ln(1/10000)/ln(.1)
S = -9.210/-2.303
S = 4 expected max. losing streak per 10,000 trades

So, you'd need to build a system with 90% winners to be comfortable with 4 losses in a row.

I use excel and vba programming at work so here are some of the formulas I use there:
Binomdist- Returns the individual term binomial distribution probability. Use BINOMDIST in problems with a fixed number of tests or trials, when the outcomes of any trial are only success or failure, when trials are independent, and when the probability of success is constant throughout the experiment. For example, BINOMDIST can calculate the probability that two of the next three babies born are male.
BINOMDIST(number_s,trials,probability_s,cumulative)

Number_s is the number of successes in trials.
Trials is the number of independent trials.
Probability_s is the probability of success on each trial.
Cumulative is a logical value that determines the form of the function.
If cumulative is TRUE, then BINOMDIST returns the cumulative distribution function, which is the probability that there are at most number_s successes; if FALSE, it returns the probability mass function, which is the probability that there are number_s successes.
Remarks: Number_s and trials are truncated to integers.

1. If number_s, trials, or probability_s is nonnumeric, BINOMDIST returns the #VALUE! error value.
2. If number_s < 0 or number_s > trials, BINOMDIST returns the #NUM! error value.
3. If probability_s < 0 or probability_s > 1, BINOMDIST returns the #NUM! error value.
4. The binomial probability mass function is: b(x;n.p)=[n over x]p^n(1-p)^n-N
5. where [n over x] is COMBIN(n,x).The cumulative binomial distribution is:
6. B(x;n,p) = [n over ∑ y-0] b(y;n,p)
7. 6=Number of successes in trials
8. 10=Number of independent trials
9. 0.5=Probability of success on each trial
10. =BINOMDIST(A2,A3,A4,FALSE)
11. Probability of exactly 6 of 10 trials being successful (0.205078)

If you have Excel you must also look at critbinom, hypgeomdist, negbinomdist & poisson depending on your need.

Best Regards, Chris

Twinchell, would you please elaborate on this statement? I like the sound of optimal returns. How I get there is irrelevant. My psychic trading partner is Spock.

I remember how when I took my first live trade, I felt like I was commiting a "sin" = taking hard earned money in vain. After a while, this feeling wore off.

I remember when I was first margined out. I felt like I had commited a "sin" - that a disaster had occured. Then I realised that the world went on. Since then I have been deliberately margined out countless times - on both live and practise accounts, and it carries no charge whatsoever. It's part of my trading system to be regularly margined out. Fear and greed should play no part whatsoever in a reason based trading system.

I am an extreme trader by any standards, but I am also a logic based trader. (Actually, I am not really a trader yet - but I am a trader in the making. And I expect to be a great trader some day.) I just saw the film - A Good Year, directed by Ridley Scott. (I highly recommend it.) The hero is a London fund manager of a huge fund who is a daredevil trader. The opening scene was exhilerating for me - fifty or more traders in a room full of screens and technology that puts NASA to shame coordinated by this brilliant daredevil trader - earning hundreds of millions on some precision-timed trading maneuver.

I don't recommend high performance precision trading to anyone to whom it isn't suited, but at the same time re-interate that logic and mathematics should guide this process, not emotion, sentiment, superstition, rumor, conventional dogma or any illogical hocus pocus.

I regularly, deliberately and routinely violate quite a few of your "rules of trading" above - most notably the injunction not to try to predict the turning point of trends - and while I understand they are sensible guidelines, don't accept them as engraved in stone until I have thoroughly examined them and found them to be genuinely non-productive.

Itme, that's just my personal opinion. I can't personally trade through an 83% drawdown. I can't mentally cope with the fact that a $10,000 account could potentially be at $1,700 at any given time. I would give up. That's just me.

Like I said though, every person has to define their own maximum drawdown. It's different for everyone. For me it's around 30%. For you it might be 100%. You might be comfortable with the fact that you could lose an entire account. That's just not realistic to me.

I have to admit that optimal returns are very interesting. In theory, it would be possible to take $100 using an optimal risk totally disregarding drawdown and achieve the same end goal as taking $10,000 and trading within a given bounds. You see, it would be fine to me to start an account with $100 and accept the fact that I could lose it all. No biggie. But what if that grows to $5,000? Are you still comfortable with the fact that you could lose it all? What about $50,000? Like I said, this is in theory, in practice there are a few obstacles to overcome, such a liquidity, margin, etc. Is it possible? I have no idea.

I totally agree with you. Those "rules" are not engraved in stone, but it is in the majority of people's interest to follow them. I believe trading is what you make of it. If you want to be the first trillionaire, then you should be looking into high precision trading systems that risk an exuberant amount to return an exuberant amount. I'm not like that. I don't want to be a trillionaire, or even a billionaire. Give me a few million and I'll be happy. The paths between these are different. I'd rather take a shorter path to millions than a long and drawn out one to billions. I don't care about optimal returns, even though they are extremely interesting. I want something that is very realistic to me, and very possible.

Agreed, Twinchell, everyone is different, so there is no one trading system for everyone. However, some things are universally true. Such as the risk inherent in day trading.

Willingness to risk is a pre-requisite of ability to gain. If the process is logical, then it should theoretically work. If it doesn't work - then the analysis was faulty, the trader deviated from the plan, or an improbable event occured. One can't escape the laws of probability.

Everyone takes a risk when entering a trade. A calculated risk. The size of drawdown should be irrelevant, as long as it doesn't cause the suspension of the trading program, or interfere with its efficiency. The probability of achieving one's target at the end of the trading program is all that should guide one's conduct. If the goal is to make alot of money with an small initial bankroll, then one must trade systematically and logically, and that includes taking relatively large calculated risks.

Drawdowns are a part of trading. The quantity or percentage of drawdown has no special importance to me, from an analytical point of view. The final outcome is all that matters. The way I see it, one is risking one's initial investment, not the money which accrues during the trading program.

One should not identify with the money in one's trading account. Until one has terminated one's trading program, the money in one's account is not one's own, it is capital that is invested in a trading program that is theoretically at risk of being lost. That is the constant warning in the Forex business. Do people really take that warning seriously? They should, because it's true. We must be willing and able to lose our initial bankroll, because it will happen sometimes. We must face this possibility squarely, and having digested this possibility, proceed logically and systematically towards our goal, whatever that is. My goal is large amounts of money, in a relatively short time. The same is true for most traders. It isn't easy, and alot of learning is needed. But the goal will be reached sooner if all superstition, myth, dogma and sentimentallity are relinquished early on in the process. This is just as true in the case of a slower, low risk method as in the case of a high performance, high precision trading system.

Let me elaborate on this a little further. A little consideration of the Itme Theorem of Return on Capital from Short Term Investments (located here: From $7.00 to $770 Billion - Satire ) helps one realise that the performance of a trading program is contingent on only two factors - 1) accuracy and consistency of predictive ability (typical reward / risk ratio) and 2) willingness (and ability) to risk.

The only impediment to the first factor is limitation or degree of knowledge about market behavior - how capable one is at predicting market behavior. This boils down to accuracy - capacity to predict a point of directional reversal at both ends of the trade - beginning and end. The ability to accurately predict a potential market reversal at the beginnning of a trade determines entry price and stop size. The ability to accurately predict a potential market reversal at the end of a trade determines exit price. The impediments to the second factor are degree of knowledge of market behavior, and psychological stamina. The risk factor is thus limited by not one, but two factors. Both can be modified.

How? It is possible to acclimatise oneself to drawdowns through systematic behavioral conditioning and by education and logical reflection. Also - social factors can play a significant role. Do not encourage or entertain irrational or emotional reactions to normal events such as losses and attendant drawdowns. Do not expose yourself to people who model or ellicit these reactions. Do not indulge in them yourself.

Degree of market knowledge can increase through education and research. At the very least analyse all one's own trades thoroughly, including proposals for improvement. I believe that this is one of the great keys to eventual success, as it facilitates self awareness and honesty - truthfulness - one of the foundations of success, along with persistence, industriousness, intelligence, systematicallity and firm discipline.

The twin goals of the logical trader should be to maximize trading precision and risk factor - because these are the only two factors determining the efficiency of the trading program. To increase risk factor one must improve win rate, typical reward / risk ratio, skill (ability to accurately implement the trading system), decluster losses if possible, and eliminate psychological impediments to a higher risk factor.

With a clear eye on the twin balls - improvement of market knowledge to enhance reward / risk ratio and win rate (which in combination with psychological impediments determine maximum risk factor), and increase of risk factor through improvement of market knowledge and eliminating arbitrary psychological limitations - the trading "game" can be systematically improved.

I just read the opening post in this thread: Why we wont u to be rich? and feel that there is alot of practical wisdom from successful investors summarised there (don't pay attention to the spelling errors).

Thanks for the comment.

Glad you enjoyed it.

Thanks for the feedback.

That's very kind of you.

I appreciate it. Thanks again.

Im glad I can help so many people. It makes me feel all warm and tingly inside to hear this.

Ladies and Gentlemen, do we have our next Mr. Booker????

hey ces


is that a piccy of the bull, at the bull ring? and are you a fellow local

Just wanted to BUMP this post up to activate it, one of the best I have ever read here, in this category anyway, and it is not malacious as you might think when you first see it! Be sure to scroll and read all of it

Actually the topic of the thread deserves to stay active also, wonder if twinchell is still visiting here?

that post gives me a long in my shorts....

fyi : last activity jan 12, 2007

Yes, I can read too you know !!!

just kidding, actually, that piece is something that you could have written, maybe you could use it as your signature

very good thread. maybe somebody can say some things about monte carlo simulations and how this relates to trading. i'm very interested in the maximal drawdawn and typical drawdawn problem.