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Chartists and Trend-followers Need to Trade More Frequently

Besides the fact that chart patterns are mostly random formations (see head and shoulders, double bottoms, triangles, flags, etc.), chartists also face some practical problems having to do with position size.  Trend-followers also have similar problems. This is because position size depends on risk and not on profit target objective.

Traders that rely on technical analysis and especially on chart patterns usually manage a low win rate but hope they can make multiples of what they lose on the average. However, they are constrained by position sizing.  This means that they may need to trade more frequently to accumulate the same profits as compared to a trader with a high win rate and a risk:reward ratio of one. To see this, let us consider the two cases:

Case A: win rate = 30%, reward = 3, risk = 1 (usually a technical analysis chartist or trend-follower)

Case B: win rate = 70%,  reward =1, risk =1 (usually an algorithmic trader)

In case A the expectation is equal to

EA = 0.3 x 3 – 0.7 x 1 = 0.20

In Case B the expectation is double

EB= 0.70 x 1 – 0.3 x 1 = 0.40

Since net profit is equal to expectation times the number of trades, the trader in Case A must trade twice as frequently as trader B to make the same profit. But this is NOT the only problem here. The trader in Case A has a much higher probability of ruin due to the low win rate. Risk of ruin is a function of win rate. The higher the win rate, the lower the risk of ruin.

Trend-followers attempt to solve this problem by adding to position and diversifying in several markets. This can result in risk levels that are difficult to quantify. It may not be an exaggeration to say that most trend-followers do not know their risk level or have control over it.

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