Insight Into System Capability
Improve Your System With The Profitability Rule
by Michael Harris
What are the capabilities and limitations of your trading system or investment strategy? You can ensure your system or strategy has a high probability of meeting your profit objectives by using this simple model as a measure of profitability.
Most traders spend time trying to develop mechanical trading systems and often end up lost in a maze of indicators and techniques that produce dismal results. They may not fully understand the fundamental tradeoffs present in trading system design, or even worse, underestimate the influence of those tradeoffs.
The profitability rule I present in this article sheds some light on the capabilities and limitations of trading systems, especially when commissions are factored in. It provides insight into systems operating in different time frames such as intraday or short-term, as well as trend-following systems. It would be worthwhile for every trader to understand how this simple rule can be used to realistically analyze the profitability of a system.
THE PROFITABILITY RULE
The profitability (P) of a trading system, or investment strategy in general, is defined here as the ratio of the number of winning trades or investments to the total number of trades or investments made, a number ranging from zero to 1 (zero to 100%, in percentage terms)....
Figure 1: Minimum required profitability. Minimum required profitability is expressed as a function of the ratio of average winning to average losing trades.
...Continued in the September 2002 issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the September 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.