you could come up with a system that only kept you in the market 50 percent of
the time, while the profit per share traded only decreased 40 percent? To assume
the same effective risk as in the buy-and-hold system, you now can trade twice as
many contracts per time units spent in the market. But with only a 40 percent drop
in return per contract traded, the final net outcome measured in dollars will still be
20 percent higher than it would have been for the buy-and-hold strategy.
For example, say that investing in 100 shares in a buy-and-hold strategy
resulted in a profit of $100. Then, trading 200 shares at the time, being in a trade
only 50 percent of the time, would result in a profit of $120 [100 * 2 * (1 0.4)].
Hopefully, the final risk–reward relationship will be even better than that,
because the whole point of a trading system, as compared to buy-and-hold, is that
the system will keep you out of the market in bad and highly volatile times, when
the result of the buy-and-hold strategy will fluctuate widely. Furthermore, with a
trading system, you have the opportunity to reinvest previous winnings to speed up
the equity growth even further, which you cannot do with a buy-and-hold strategy.
Remember that during the testing procedure, we’re only interested in how
well the system captures the moves we’re interested in and how likely it is that it
will continue to do so in the future. We are not interested in how much money it
could have made us, whether we could have traded without any additional costs or
not. Many times the value of these costs also will vary relative to the value of the
market and the amount invested in the trade, which also is something most system-
testing software cannot deal with.
For example, in a trending market, the commission settings will have a larg-
er impact on your bottom line the lower the value of the market. We already
touched on how the dollar value of the moves is likely to increase with the value
of the market. Subtracting the same cost for slippage and commission across all
trades in such a market will only lower the impact of the low-value trades even fur-
ther. The same goes for comparing different-priced markets with each other.
To test a trade, first calculate the expected percentage move you are likely to
catch, then transform that move into dollar terms in today’s market by multiplying
the percentage move by today’s market value and the number of shares to trade.
Then deduct the proper amount for slippage and commission. If this dollar value
still looks good, you should take the trade.CHAPTER 1 Percentages and Normalized Moves 13