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Market Statistics, Trading Strategies

Never Pull the Trigger Unless You Know the RIsk and Reward

Everyone can use a fancy stock screener with dozens of technical and/or fundamental criteria and find a few charts that look good. It is quite possible that one will find charts that satisfy specific criteria every day due to the large number of available tickers. That is nothing to get excited about because pulling the trigger before knowing the risk and reward of a setup leads not only to random trading but very frequently to account ruin.

Unless the risk and reward of a setup are known and are statistically significant, screening for potential setups and choosing those that satisfy some criteria that someone thinks are the proper ones to use is no different than a blindfolded monkey throwing darts at the stock quote section of a newspaper. If the monkey will profit, the random stock screener may profit. But during times when market performance is flat or negative, the monkey will lose and the stock screener will lose. Do not look for complicated answers for the reasons. The market will not reward during rough times unskilled traders. The markets reward skill, whether in technical or fundamental stock selection. Obviously, using any tools to screen for stocks does not require any special skills other than setting a few parameters and hitting the GO button. Who is so naive to believe that this process can lead to substantial profits to cover commission, operations and opportunity cost?

Before pulling the trigger one must know at least the risk and potential reward of the setup. This is not easy to do in the majority of cases. Even if that is done, the issue of statistical significance remains. One approach involves simplifying the screening criteria and backtesting the results of the screening process. This takes extra time and requires some special skills. This is not something that the average user of a stock screener can accomplish and this is just one of the edges quant houses have over individual investors.

So, if you have been trading like that for a while, meaning that you have been using one of the many stock screeners available in the Web or even you have been following the advice of a “guru” who essential does that for you,  and you have made at least 100 trades, I will suggest here a simplified process of estimating the risk and reward potential of a setup. Maybe you can escape doing the quantitative analysis if your procedure for selecting stocks has remained more or less consistent in terms of what you are looking for, criteria used, etc. If that is the case, just average the profit/loss of all the trades you have made. This is the average trade and for sufficient samples it is equal to the expectation, a.k.a. expectancy, of your next trade:

Sum of all trades/number of trades = E[T]

Next, average the losers only. Add the losers and divide by their number. Let us call the result AvgL

Now, assuming consistency in your procedure,  E[T] is what you should expect to make on your next trade. AvgL is what you should expect to lose.

If E[T] is a lot less than AvgL, or negative in case of a net loss, then you may want to think about changing the particular procedure for selecting stocks and/or looking for a different one. Of course, until you make 100 trades to have an estimate of the two statistics, you are facing a risk of ruin.  But if you manage to stay in the black, the size of the average loser in relation to expected gain can offer some hints on whether you are doing something wrong.

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