High probability trading systems

It is easy to build a system with a high winning percentage. Set your stop loss at 10 times the size of your profit target and you will have a system that wins 90% of the time. The problem with a system like this is that the 10% losses will take away all of your profits. You simply can not gauge a trading system on probability alone.

To find out the rest of the story you have to calculate the expectancy of the system. Here is the formula for expectancy.

(Winning % * Average Profit) + (Losing % * Average loss) = Expectancy

Here is an example for a system I tested:

( 91.81% * $101.78 ) + ( 8.19% * -970.00 ) = $14.00

or

( .9181 * $101.78 ) + ( .0819 * -970.00 ) = $14.00

This system was always long and a new trade was opened as soon as a stop or target was hit. The profit target was set to $100 and the stop was set to $970. It won 91.81% of the time and lost the other 8.19%. The average winning trade was $101.78 and the average losing trade was -$970. If you put these figures into the expectancy formula, you can see that the expectancy is $14. That means that over a long period of trades you can expect to make an average of $14 per trade. If you factor in commissions and slippage it really isn’t that good.

What you are looking for is a system like this:

(91.81% * $101.78) + (8.19% * -200.00) = $77.06

This is the Holy Grail that everyone is looking for. Don’t get excited I haven’t found it yet.