A chartist I know sees a massive top formation in S&P 500. I replied to him that he has been wrong several times in the past with such random formations. He argued that although he is frequently wrong, almost 70% of the time, if he can make 4 times what he loses on the average then he can profit longer-term. Math says forget about it.
It can be shown that traders of classical chart formations that take several weeks or even months to form have to trade more frequently than short-term traders to realize the same profit. Given the relevant timeframes, chartists must trade in many different uncorrelated markets and that may be hard or even impossible. In order to see that, let us consider a chartist and a short-term trader with the following parameters.
Chartist: win rate = 30%, reward = 4, risk = 1
The chartist has low win rate but the claim is that he makes 4 times more than he loses on the average.
Short-term trader: win rate = 65%, reward 2, risk =1
The short-term trader has payoff ratio of 2 but at a higher win rate.
The average trade for the chartist, avgTc is given by:
AvgTc = 0.3 x 4 – 0.7 x 1 = 0.5 (1)
The average trade for the short-term trader, avgTs is given by:
AvgTs = 0.65 x 2 – 0.35 x 1 = 0.95 (2)
Note that the average trade is equal to the mean of the population only for sufficient samples. Only in that case the average trade values become the expectation.
(1) The average trade of the chartist is nearly half that of the short term trader. Thus, the chartist must trade twice as much to make the same profit.
(2) Since on the average trades from classical chart patterns last weeks or even months, the average trade will converge to the expectation in a long time. For example, if we assume that a typical chart pattern takes 3 months to form, then for a sufficient sample of 30 trades it will take 7.5 years of data in all markets combined. In contrast, a short-term trader needs a few months to accumulate a sufficient sample to test a trading method
The conclusion is that any claims of high payoff ratios (average win to average loss) to justify charting and trading based on formations that take several weeks or even months to form come in conflict with simple math and usually involve denial of reality. Ruin when trading with low win rate is highly probable and most likely to occur before the average trade converges to expectation.
The simple math above explains why trading with classical chart patterns has been one of the most unsuccessful methods and basically it has acted as a wealth transfer mechanism to market makers and other professionals.
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