How to Increase Your System’s Edge
One method of trading that a lot of our forex traders’ use, is
holding their position for only a very short amount of time and a very small
number of pips. Essentially what they are trying to achieve is a high accuracy
edge.
A trading systems’ edge is what is going to make it profitable in the long run.
A great example of an edge is a blackjack game at a casino. Based on the rules
of the game, the house has a very slight edge over the player. After a lot of
repetition, a great sample size of hands is played and the casino exploits the
edge and makes a lot of money. This should be the same with any system. It is
critical to understand that losses will happen and the only way to win is have
an edge over the long run.
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With this in mind different systems have different types of edges. In this
article I will show you a great risk management trick called the Martingale that
will help you maximize the returns of a high accuracy system. Before I go on,
let me briefly describe what the Martingale Strategy is. Then I’ll show how it
can be used. Here’s how it works in theory:
In the Martingale Strategy you increase your position size when you have
multiple losing trades in a high accuracy system. When the system’s performance
reverts back to the mean and begins to win again, the losses are quickly
recouped because of the increased size of the winning trades.
Okay, let’s get started.
First, let’s talk about a few of the key components that a trading system or
strategy should have:
Reward/Risk Ratio and Accuracy
The reward/risk ratio (RRR) is the expected profit divided by the expected loss
on a particular trade. How much you are risking and how much you expect to make.
Accuracy is simply the percentage of trades that you are correct on.
Your reward/risk ratio for a particular system has to be consistent with the
accuracy (winning percentage) of a particular system. I will go into a couple of
examples below, but the bottom line is that the RRR and the Accuracy are usually
inversely correlated. In other words, the higher the RRR, the lower the accuracy
is, and vice versa.
Example:
If you are using a system that is only holding for a few pips and you are trying
to achieve high accuracy, you don’t need a high RRR at all to have positive
expectancy. For example, if your winning percentage is 90%, you can afford to
have an RRR of .5.
Using a simple example of 10 trades:
When adding advanced risk management concepts like dollar cost averaging and
pyramiding and a Martingale principle, you can enhance your expectancy further
to create some really nice results.
In this article, I will explain how to maximize the returns on a high accuracy
system by using the Martingale principle. We at forexyourself.com have numerous
proprietary trading accounts and are currently working on a high accuracy system
for forex that takes advantage of this very principle, and the system is showing
very promising results.
Before I talk any further about this principle I need to set one golden rule in
place. This is what is called the 2% Rule. According to this rule, a trader
cannot risk more than a certain percentage of his account on any single trade.
In my opinion, this is actually the holly grail to trading any instrument. Since
I am very conservative, for me the number is 2%; some traders like to go as high
as 5%. I would strongly recommend not risking more than 5%, especially on a
highly leveraged vehicle such as forex.
Essentially you have to determine position size based on this rule. The
calculation is very simple and we actually have a calculator on our website
https://www.forexyourself.com/risk-calculator.php.
Example:
Total account size: $100,000
Maximum single trade loss %: 2% {set}
Maximum single trade dollar loss: $2,000
Now you have to calculate your loss on a single contract based on the distance
from your entry to your stop and than divide it into your maximum single trade
dollar loss to obtain your maximum position size in contracts or shares.
Entry: 1.1850
Stop: 1.1830
Max $ loss per contract: 20 pips = $200
Maximum single trade dollar loss from above: $2000 (2% of $100k)
Optimal position size: $2000/$200 = 10 contracts
Now that you know how to determine the upper limit to your position size, we can
discuss the Martingale strategy.
A high accuracy system will be correct 8-9 times out of 10. The only drawback to
this is that your losses will be larger than your winners, as we discussed
above. So once you hit a loss, it will take a big bite out of your winners. What
if there was a way to recoup that loss very quickly? The Martingale strategy can
help you do just that.
First you must understand that it is not a good idea to trade near the upper
limit determined by the 2% rule when using a Martingale strategy. So if the
largest position you can take is 10 standard lots, when using a Martingale
strategy I would recommend you start with 2-3 mini lots.
Since it is statistically fairly unlikely that you will have a great deal of
losing trades in a row in a 90% accurate system, you can play with the position
size to put the odds in your favor.
Let’s say that you have an RRR of .5; you will loose $2 for every $1 that you
win.
As you accumulate your winning trades, keep the same position size (let’s say 2
mini lots). Once you hit your first loss, you can double the position on the
very next trade because since the system has high accuracy, the chances of 2
losses in a row are not very high. If the next trade does turn out to be a
loser, you double the position again. You can double up to your maximum position
size calculated by the 2% rule. Once you hit that size you should just keep that
size as you trade until you hit your next winner. However, because you are
starting out with such a small portion of your account, this is not likely to
happen.
Let me give you an example with the figures that we used above. Suppose you have
a system that is 80% accurate and has a RRR of .5, so you make $1 on your
winning trades and lose $2 on your losing trades. Let’s say your 1st and 7th
trades were losers. You are getting 10 pips on your wins and losing 20 pips on
your losses. Let’s run through the example on a 10 trade sample size:
Martingale +60 Pips
No Martingale +40 pips
You can see how the martingale enhances the system.
Now let’s look at an example with 2 loosing trades in a row and see if the
martingale helps.
Martingale +50 Pips
No Martingale +40 pips
So keeping the same accuracy, the Martingale system even works with 2 losing
trades in a row in a 10-trade sample size.
When using the Martingale strategy, I recommend keeping a few things in mind:
1. Trade very small — positions can run up a lot by doubling them so start out
very small so that you don’t get into trouble.
2. Never Exceed the 2% Rule — Never exceed your maximum single trade size no
matter what.
3. Use this only on a high-probability system.
4. Use back testing to determine your accuracy from a large enough sample size.
Using the Martingale approach can be very beneficial in increasing performance
of high probability strategies. I will discuss a few of the high probability
strategies in our seminars and further articles. This strategy must be used in
conjunction with the 2% Rule and may be use in conjunction with other risk
management principles.
Alexander Nekritin has a been a professional trader for over 10 years and is the Founder and President of TradersChoiceFX.com. TradersChoiceFX is a Metatrader Forex Brokerage firm that is able to enhance their clients FX trading success through their through their Forex bonus program. TradersChoiceFX also strives to set clients up with the ideal environment for their Forex strategy. You can download a free Metatrader Practice Account from TradersChoiceFX and get instant access to a special report that will teach you how to use a Forex bonus program to improve your success as an FX trader.
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