you are willing to lose in each and every trade, for the possibility of making a prof-
it, just as you’re willing to risk a certain amount to get a 25 percent yearly return
on your dental practice.
Given the above numbers, it also is possible to calculate how much money
you risked. In the first example, you made a total of two bets for $1 each, which
means you risked $2 to increase your capital with $1. Consequently, your return
on the amount risked was 50 percent (1 / 2). In the second example, your capital
also increased with $1, but this time you had to risk $3, which resulted in a 33 per-
cent (1 / 3) return on the amount risked. In total, you risked $5 to make $2 for a
return of 40 percent on the amount risked.
Now, instead of talking about a few individual bets, let’s compare each exam-
ple with a year’s worth of trading, risking $1,000 in each trade. For the first year
100 losers and 100 winners produce a profit factor of two [(100 * 2,000) / (100 *
1,000)], and the return on the amount risked is 50 percent [(100 * 2,000 100 *
1,000) / (200 * 1,000)]. For the second year, with 200 losers and 100 winners, the
profit factor and the return on the risked amount will be 1.5 and 33 percent,
respectively. (And for the two years combined, the profit factor and the return stay
at 1.67 and 40 percent, respectively.)
Now, assuming a profit factor of seven for each year, let’s try to calculate
backwards to find out how large the winners need to be and what the return on the
risked amounts will be, given that we have 50 percent profitable trades in year one
and 33 percent profitable trades in year two. For year one, it’s easy enough. The
winners need to be worth $7,000, so that the calculation for the profit factor will
look as follows: (100 * 7,000) / (100 * 1,000). If that is the case, the return on the
amount risked will be 300 percent [(100 * 7,000 100 * 1,000) / (200 * 1,000)
6 / 2]. For year two, to end up with a profit factor of seven, each profitable trade
needs to be worth $14,000, so that a profit factor of seven can be calculated
according to: 100 * 14,000 / 200 * 1,000. The return on the risked amount will
then be 400 percent [(100 * 14,000 200 * 1,000) / (300 * 1,000) 12 / 3].
Now, I’m asking you, when was the last time you saw a trader (professional
or otherwise) produce a long-term sustainable return on total amount risked of 300
to 400 percent a year? Heck, when was the last time you saw any trader produce a
long-term sustainable return of 40 percent (a profit factor of 1.67, with 40 percent
profitable trades)? Never, I say. A return of 40 percent a year simply isn’t sustain-
able in the long run, much less a return of 300 to 400 percent. Sure, every so often
a lucky few manage to produce spectacular numbers over a year or two, but that is
only because everything goes their way during that period, with a trading strategy
or system using a long-term profit factor that could be as low as 1.25.
If it really was feasible for a professional money manager to trade long-term
with a profit factor of seven, it would be a piece of cake for someone like me, who
has dabbled around with this for ages, to come up with a system with a profit fac-
tor of at least four and more than double my money every year. But I still make theCHAPTER 4 Risk 49