bulk of my money analyzing the markets, rather than trading them. And you, I
assume, would not have bought this book if you already were doubling your
money every year. Go figure.
Remember how earlier we calculated the risk–reward relationship for each
individual trade to be 2:1 and 3.5:1, using a system with 50 percent and 33 percent
profitable trades, respectively? Can we agree that those numbers are pretty much
what any trader could ask for, professional or not? (The chart with its support and
resistance levels doesn’t look any different for you than for the professional money
manager.) Well, in the above examples, with a profit factor of seven, these
risk–reward relationships come out to 7:1 and 14:1, respectively. Where on Earth
would those moves come from, when all we can agree to is that 3.5:1 is as good
as it will ever get on a long-term, sustainable basis?
Nevertheless, say that you happen to have a system with a profit factor of
seven, a risk–reward relationship of 7:1 and 50 percent profitable trades. What
would happen if the market, unbeknown to you, changed its characteristics ever so
slightly so that you would be better off with a $2,000 stop loss instead, and that it
would be better with a profit target at $6,000, for a risk–reward relationship of 3:1
(6,000 / 2,000)? More trades would be stopped out with a $1,000 loss, and fewer
would be stopped out with a $7,000 profit. Say that every other would-be $7,000
winner now turns into a $1,000 loser, and most of the remaining winners are
stopped out for inactivity at $4,000. In that case, you’re down to 25 percent prof-
itable trades and a profit factor of 1.33 (4,000 / 3,000). Now, with such a high per-
centage of losing trades, you won’t always experience one winner for every three
losers. What if you have nine losing trades in a row? Then you need at least three
winners to take you out of the drawdown, and with only a 25 percent likelihood of
each trade being a winner, chances for that to happen aren’t very high. All of a
sudden your Holy Grail system has turned into something very nerve-racking to
deal with, with drawdowns that most likely will force you out of business, even
though it still has a profit factor as high as 1.33.
What I’m trying to say is that such a highly specialized machine as a trading
system with a profit factor of seven will break apart very easily. And when one
part goes, the real trouble starts. Even though it still might be profitable, the
plunge in the profit factor will be deep, and it will be very nerve-racking to trade.
And what if the relationship between that very complex pattern or indicator setup
demanded for such a system, and the move that follows it, cease to exist com-
pletely? Compare such a system to the cheetah we talked about in the Introduction:
You will have one dead trading system, or one that produces nothing but losers.
If you ask me, any system with a back-tested profit factor of more than two
is suspect. To build a robust trading system that is likely to continue to perform
well in the future, make sure that the underlying logic is sound and simple, that the
trading rules are as simple and as few as possible, that it works just as well for a
wide range of parameter settings, that it produces plenty of trades at all times, and50 PART 1 How to Evaluate a System