- visualise your dominant trading style: mean reversion or trend following
- visualise and quantify your trading edge both in aggregate and at individual security level
- materially improve your trading edge: we posted some techniques and tips. Try them and see the results for yourself
The trading edge formula
Visual representations of the trading edge of the styles
- the hump of the win rate is above the 50% hit ratio line
- The long left tail looks like a fin.
- Low win rates: between 30 to 40%. The peak of the loss rate is below the 50% line
- Short left tail
- Long right tail
Step 1: Diagnostic
Step 2: Understand and measure the risks associated with your dominant style
- Mean reversion: The key risk measure for mean reversion strategies is the Tail Ratio. Tail ratios of 0.3 and below present severe risk of blow-ups. For example, some strategies may clock +0.5% every month, but have a sudden -4% drawdown. This would take 8 months to recover, which is probably beyond the patience threshold of many investors.
- Trend following: The key risk measure for trend following strategies is the Gain to Pain Ratio: trend following strategies have low win rates. For example, if You allow each loser to dent your capital by -1%, assuming a 40% win rate, winners will have to average +1.5% just to break even.
Step 3: Improve your trading edge
Techniques explained below are designed to nudge the shape of your distribution. Your trading edge is the shape of your distribution. Ideally, You want something that looks like this:
- High win rate: not only does it feel better, but it compounds faster
- Long right tail: ride your winners and allow your capital to appreciate
- No left tail: cut your losers
- Symmetrical distribution on the Long & Short side: identical rules on both sides of the book
The key to success for mean reversion strategies is to increase the tail ratio. This can be accomplished in two ways:
- Stop loss: a strategy without a stop loss is like a car without brakes. As a rule of thumb, a stop loss should not be further away then twice the 90th percentile of your profits. Beyond that limit, the period of recovery may be too long to be commercially acceptable
- Elongate your right tail: mean reversion strategies do not allow winners to fully mature. This simple technique can allow winners to develop while preserving profits. Instead of closing the entire position, close no more than 2/3 and place a trailing technical stop loss on the remainder. Do not place a valuation stop loss as it will exceed your comfort zone.
- Shops do not restock on products they cannot sell; they mark down the inventory and clear it at a discount. Similarly, do not double down on losers, accept your loss and move on.
- “Value” investors usually sell their positions to their “momentum” colleagues, only to sigh in despair when prices subsequently double or triple. Next time, sell them a portion of your holdings and enjoy the ride with them. Worse case scenario, if it does not work, your stop loss will take you out and protect your profit.
- Stop Loss is the second most important variable in your trading system, after the most volatile place on the market, that is the grey box between your left and right earlobes. Stop loss has a direct impact on three out of four components of the trading edge: Win rate, Avg Win, Loss rate. Make a habit of placing your stop loss as your enter your orders
- Would You allow tenants to stay rent free in a building You own ? Every time You say yes to a free loader, You say no to a good customer, so make a habit of evicting poor performers
- Improve your win rate: assuming average loss stays the same, any improvement in the win rate will have a material impact on the trading edge.
File user’s manual
- Time and Date: the information is organised in chronological order on the Table sheet
- Ticket No: this assumes that all trades have a unique identifier
- Symbol: The table sheet calculates the trading edge of each security in a timely manner
- Type: Buy/Sell, this allows rapid sort
- Buy/Sell Lots: this field is useful for multiple entries/exits
- Profit: this is an absolute USD P&L
- Contribution: this is a simple P&L / Contribution field. There is no currency conversion, benchmarking or modified-Dietz time-series. Relative performance calculation should take place in this field
Pivot Table settings
- ROW fields in Tabular Form: In the PivotTableFields: click on Field Settings: in Layout & Print table: Click on Show items in tabular form
- ROW Fields SubTotals deactivated: In the PivotTableFields: click on Field Settings: SubTotal & Filters table, Subtotals: click None
- PivotTable Options Totals Columns deactivated: Right-click anywhere in the PivotTable, go to Totals & Filters, uncheck Show grand totals for columns
- Column Label: Click on Select All to allow automatic refreshing
- Run this analysis periodically and keep track of your evolution to receive the full benefits
- Truncate data: the current file looks at the entire population. Segment your trading history into blocks when your strategy performs, when it does not.
- Comment and annotate entries/exits. You will realise that a bit of finesse on exit will go a long way. It is useful to keep track of exits
People who keep track of their weight are 30% more susceptible to reach their weight loss target. The Trading Edge Visualiser tool will help You understand who You really are. It has the potential to transform your trading game, as it continues to do so for me.
It is 100% free, so download and play with it!