relationship over a few trades will be lower. To calculate the exact relationship we
need to know exactly how many losers are likely for every winner; if those num-
bers are missing, we can estimate the number of winners and losers based on the
system’s characteristics and our experience.
Given the current volatility of the stock market, it’s fair to assume that a
1-percent stop loss is quite tight, which should result in a rather large amount of
losing trades. Assuming that only every third trade will be a winning trade, and
that the average loser is equal to the stop-loss level of 1 percent, we can calculate
the value of the average winner according to the following formula:
AW (AT * NT AL * NL) / NW
Where:
AW Value of average winner
AT Value of average trade
AL Value of average loser
NT Number of trades
NL Number of losers
NW Number of winners
In the above $7,200-drawdown example, we assumed the average trade to be
worth $500 in today’s market. Assume further that we are currently tying up
$100,000 per trade, which then makes the average profit equal to 0.5 percent of
both the tied-up capital and the expected move of the stock on a one-share basis.
With three trades, of which one is a winner and two are losers, and the value of the
average trade being 0.5 percent, the average winner comes out to 3.5 percent [(0.5
* 3 1 * 2) / 1]. The actual risk–reward relationship is then 3.5:1.
With this information at hand, we can calculate how many winners in a row
we need to take us out of a drawdown. Continuing on the $7,200-drawdown exam-
ple, it will take you three winning trades in a row to reach a new equity high if our
average winning trade is worth $3,500 [Integer(7,200 / 3,500) 1].
Now, three wining trades in a row doesn’t seem to be too hard to produce, but
because we know that only every third trade on average will be a winner, ask your-
self how likely it is for this to happen. Provided it’s highly unlikely that two or
more winners will occur in a row, but very likely that the losers will come in pairs
and that your average loser is for $1,000, then you know it can be expected to take
at least 10 trades before you can see the sky again, provided you start out with a
winning trade. If you instead start out with two losing trades, taking the drawdown
down to $9,200, everything else held equal, the estimated number of trades would
be 15.
Doing the same math, but on the assumption that as many as 50 percent of
all trades will be winners, the average winner will be 2 percent [(0.5 * 2 1 * 1)CHAPTER 2 Calculating Profit 21