Putting It All in Perspective

GBS provides the three key elements of a method that really matter.
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If you've followed my Methodology series for the last few weeks, well, congratulations: You have a strong stomach! In addition, though, I hope you have some understanding of the key ingredients you need to build your own trading platform.

To review for a second, I started a few weeks ago with the need to understand yourself. I then evolved into the need to understand your system by compiling data. These data form the bedrock you need to fall back on during those lean periods every trader eventually goes through. This week and next, then, let me try to tie up some of the remaining loose ends.

I'll start once again with a golf analogy and reveal why the handicap of the average golfer in the U.S. has not declined even 1% in the past 30 years. The truth: 99% of the golfing public is practicing, all right. Practicing the exact wrong thing!

You see, it doesn't take a genius to know that about 50% of the average 18-hole score is composed of strokes played within 100 yards of the green. And the bulk of those strokes are on the putting green. This is in direct contrast with the driver, which is in use for about 15% of your round.

Yet walk around a practice facility, and what do you see everyone practicing? Right, the driver. The driver is fun. The driver is exciting. The driver is macho.

But putting? Putting is boring. Putting is for wimps. Putting practice is for those who can't handle the big lumber! So no one practices putting. (Or chipping, or sand shots, or any other short-game aspect.) And no one improves.

Now, shoot, it's just common sense to see what it takes to lower your handicap, but there you have it: The average golfer was an 18 handicapper years ago, is an 18 handicapper now and will continue to be an 18 handicapper for the foreseeable future.

Now, the question is: Are you an 18-handicap trader? Well, you are if you're not focused on the three key elements of a method that really matter: expectancy, number of opportunities per period and holding time. Those three areas are the "putting" of trading.

Let me break them down so you can better understand.

Expectancy is simply the product of your profit percentage per win and your win rate minus the product of your loss percentage per loss and your loss rate. For example, my profit percentage per win is 5%, my win rate is 70%, my loss percentage is 6% and my loss rate is 30%. Therefore, my expectancy is 1.7% per trade, or (5% x 70%) - (6% x 30%).

Given that, I have to laugh when I see on chat threads that my 6% stop loss is "ludicrous" and "completely stupid" because as you can see above, the stop loss is academic,

as long as your profit expectancy is positive

.

As an example, I could use a 28% stop loss and a 5% profit target and come out with the same exact 1.7% expectancy as long as my win rate is high enough! As an example, a 90% win rate in this example would yield 1.7%, the result of (5% x 90%) - (28% x 10%).

Furthermore, you can easily see how you could arrive at a positive expectancy with a very low win rate. In fact, just throwing some numbers together, a 30% win rate with a 20% profit percentage, turns out to be a profitable method as long as the loss percentage is equal to or lower than 8% or so. These stops and targets are, in fact, what William O'Neil advocates, although I made up the win and loss rates. Nevertheless the raw numbers looks like this: (20% x 30%) - (8% x 70%) = +0.4%.

The bottom line is, when you look at your expectancy, don't just look at stops and limits or at win and loss rates. Instead, look at the total package.

OK, onward to "opportunities per period." No matter what your expectancy is, you will not make a great deal of money unless you have a lot of "at bats." I could generate a method with a 10% expectancy, but if my method only yielded one trade per year, what good would it be? On the flip side, if I had a method that, per the above example, yielded 0.4% per trade, it'd look puny, right? But what if that system generated 10,000 trades per year? Yeah, 10,000 times 0.4% really adds up.

This is an area, by the way, that my partner

Wesson

and I struggle with all the time. We can write scans with high expectancy or we can write scans with high opportunity generation. The trick is come up with one scan that does both.

Finally, and perhaps the most overlooked area of trading, is "holding period." You might be fortunate enough to have a system that generates both high expectancy and a lot of opportunities. But often there's a fly in the ointment: Your hold time per trade is so high that you can't take advantage of all or even most of the opportunities you generate. So what happens is you have a great method, but your buying power is always tied up because you have to wait so long to close your trades.

Think back to your business classes and recall the concept of "inventory turns." Remember how two different companies with the same dollar amount of inventory could generate totally different profits if their inventory turn numbers were different? All things being equal, the company with the faster inventory turns was more profitable because its inventory simply "worked harder."

It's no different with trading. I would much rather have $200,000 of buying power that I could "turn" 250 times per year, than $1 million of buying power that was tied up in one trade for 12 months. As an example, let's say I employed my $1 million of buying power in one trade and that trade yielded a 50% return. Hey, not bad -- a $500,000 year.

On the other hand, with my $200,000 of buying power, I yield a scrawny 1.7% per trade but do this 250 times in the same year. That method ends up generating $850,000 for the year, and that assumes I never increase my position size as my equity grows! So, less buying power, but it works a lot harder for me.

Is it starting to click now? If it isn't, don't worry: It took me years to evolve to this paint-by-numbers approach. Also, I'd be remiss not to thank Wesson for his insights into the mathematics of trading -- he's proven with extensive back-testing many of the concepts I had intuitively felt.

In addition, many of you have commented that these dialogues bear an eerie resemblance to discussions in

Van K. Tharp's

latest work,

Trade Your Way To Financial Freedom. Well, it's ironic -- I outlined these columns a few months ago, but I only started reading his book a week ago. Still, he does explore many of the same areas as I do, and I highly recommend his book.

But I'm not done yet. You understand yourself, the importance of data and the specific elements of a successful methodology. Next week, I'll wrap all this up with a discussion on paper trading, real trading, consistency and a few miscellaneous topics.

Gary B. Smith is a freelance writer who trades for his own account from his Maryland home using technical analysis. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. This column, Technician's Take, appears every Monday. Smith also writes Charted Territory, which appears every Wednesday, and TSC Technical Forum, which runs Saturdays and Sundays.

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