Wednesday, January 27, 2010

What Is Your Edge in the Markets?

For this post, I made extensive use of Henry Carstens' P&L Forecaster, a nifty tool that estimates returns for a given trading edge (average profit per trade) and risk level (standard deviation of returns).

In this exercise, I used an example of a trader with a $100,000 personal account. The trader averages 100 trades per year and averages $100 profit per trade. Moreover, we'll assume a daily standard deviation of returns of 1% or $1000. That means that about 2/3 of all trading days fall within 1%. (For the exercise, we'll ignore commissions and other fees). That means that, on average, our trader achieves an annual return of 10% on capital and doesn't take large risk.

Using the Forecaster, I ran 20 P/L simulations. The returns were as follows:

$9379, $12,097, $12,861, $9210, $10,934, $11,529, $9779, $7992, $10,694, $11,827, $10,839, $11,535, $10,300, $11,738, $9324, $9052, $13,197, $11,712, $10,736, $9683.

Two things immediately stand out:

1) There is a decent variability of returns simply due to chance (i.e., where the drawdowns hit during the 100-trade period). Whether the trader made $9000 or $11,000--a 2% difference in annual returns--was purely random. It would be a mistake to call one year a bad year and one year a good one;

2) In spite of that variability, returns are bounded. There are no $20,000 years, and there are no years of zero or negative returns. After 100 trades, your edge--or lack of it--is apparent as long as risk is reasonable. As I'll show in a future post, the risk level (standard deviation) very much affects the path of returns (including depth of drawdowns), but the average endpoint for a given level of edge remains pretty similar after 100 trades;

What that tells us is that chance plays a meaningful role in returns, even when there is an objective edge and a reasonable level of risk-taking. That being said, after 100 trades, you should know whether or not an edge is present. That is important to those training via simulator. There is no sense putting capital at risk if you can't generate a decent return from 100 simulated trades.

If you're placing 100 trades and not making money, you don't have an edge. That could reflect problems with your trading methods, your execution of those methods, or both. And if you are generating a decent return after 100 trades, you have something promising. Keep your overhead down and your risk management reasonable and you may just make a go of trading.