that it works equally as well in all markets and market conditions. If you manage
to do all this, you will be surprised at how much you can expect to produce from
a system with a profit factor as low as 1.33 or even lower.
However, the system must be designed for such a profit factor from the very
beginning, constantly taking a similar quantity of both small profits and small
losses. The system above, which goes from a profit factor of 7 to 1.33, has to rely
on one (still) relatively large winner to make up for a large number of losses. This
is a not-so desirable feature in any system.
In fact, given approximately 50 percent profitable trades, to produce an
annual long-term sustainable return of 25 percent, you don’t need a system with a
profit factor higher than 1.5, as the following math will show:
With 50 percent profitable trades, 200 trades, risking $1,000 per trade, a 25
percent return on the risked amount translates into a final profit of $50,000 (0.25
* 200 * 1,000). To make a $50,000 net profit while losing $100,000, the gross
profit needs to be $150,000. A gross profit of $150,000 divided by a gross loss of
$100,000 results in a profit factor of 1.5. With 33 percent profitable trades, 300
trades, risking $1,000 per trade, a 25 percent return on the risked amount trans-
lates into a final profit of $75,000 (0.25 * 300 * 1,000). To make a $75,000 net
profit while losing $200,000, the gross profit needs to be $275,000. A gross prof-
it of $275,000 divided by a gross loss of $200,000 results in a profit factor of 1.38.
Granted, such a system isn’t particularly exciting or sexy to trade, but it isn’t
your trading that should be exciting and sexy. It’s the lifestyle you can afford
because of it that should be all that. Note also that the return numbers discussed
so far in this chapter are based on constant-dollar risks and investments. But as we
already know, we should not measure the results in dollars, but in percentages. In
doing so, we start to compound the returns by making use of previous winnings in
trades to come. We will talk more about this in Part 4, where we also will learn
how working with compounded returns helps us tailor the risk–reward relationship
to fit our precise needs and risk tolerances for expected returns.A Sample Strategy Analysis
A very well known trader, system designer, and seminar speaker that I know of
once held a short presentation for a group of traders and analysts, among whom I
was one. Knowing about my work and my book Trading Systems That Work, and
that all the other listeners did as well, she started out the seminar by looking in my
direction while stating smugly, “Percentages, percentages, that is all fine and well,
but the only thing I’m interested in are the dollars. Percentages won’t put bread on
my table; only dollars will.”
She then went on telling the audience that her goal in trading was to make a
net profit of $1,000,000 per year, or a net profit of approximately $4,000 per day.
To achieve that, she started out the trading day by picking out a few stocks that sheCHAPTER 4 Risk 51