Monitoring Your Edge

Let’s say you’re in the camp that believes you need to have a trading methodology that gives you an edge in the market(s) in order to have a positive equity curve over time. I am certainly in that camp.

Once you have found and tested a trading strategy you are convinced gives you an edge, you are going to go ahead and start trading it. Eventually, you’ll probably hit a losing streak, also known as a draw down period. This won’t necessarily mean your methodology doesn’t work after all, or did work but has stopped working forever. Draw down periods are normal and statistically to be expected.

You’ve probably heard that you need to keep trading your system through the draw down period because you want to be in the trades that will win back your losses and then some. If you get spooked by a string of losses, and decide to sit things out until the slump has ended, then that is exactly when a huge win will pass you by. Blame Murphy.

So you do what you’re supposed to and suffer through market moods when your system doesn’t perform as it should, based on your testing. It’s painful and introduces all kinds of doubts, but you know its temporary and you’ll be in the market to catch the streak of wins that are sure to follow.

However, sometimes trading strategies actually do stop working. I know first hand that is true. Maybe someday it’ll begin working again, but you may have blown out your trading account by then.

I was thinking about this dilemma just this morning. I was wondering if there’s an indicator that can tell you if your system is failing. But its probably not likely because trading strategies are so different from each other. Then I fantasized about creating one. I’ll call it the “PE” for Performance Efficacy.

What could be measured and monitored to provide a metric for the efficacy of a trading strategy? Then I had an epiphany. It’s Win Rate! Every system has a Win Rate. Duh!

I want to monitor the Win Rate over time. If its decreasing then its time to be extra careful, or reduce the risk amount, or use other trading strategies, etc. If its steadily increasing after a draw down period then maybe I want to increase my position size, or search more vigorously to find a multiplicity of set ups.

Then I thought, how about using a simple moving average on the Win Rate. OK, sounds good, but what would be a good number of trade events? Well, let’s use the number suggested in the “tradetesters.substack.com/p/how-many-samples-do-i-need“ post, which is mid-thirties. My favorite number is 36 but 34 is a nice Fibonacci number. I doubt it matters if its PE(36) or PE(34). Either way, every update of the PE() will be calculated on a statistically significant sample set.

A win indication of “1” and fail indication of “0”can be manually recorded in a spreadsheet for each trade. The PE(36) is just using the spreadsheet on every row to calculate SUM(range)/COUNT(range) over a range beginning with the current row and the 35 rows above it. Then use the charting functions of the spreadsheet to visually determine how your edge is performing.

I’m going to begin doing this today .

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