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itively or negatively. Consequently these trades are not independent because they are correlated to each other. This is why the probability of experiencing consecutive losing or winning trades increases while trading. Unlike the independent coin flip, which statistically is 50 percent likely to come up heads or tails, trading is typically not an independent affair having 50 percent outcomes. This is because of the trader's methodology, and how he or she perceives the market. As successful traders assert their discipline and trade according to their methodology, they will generate a statistically large enough universe of trades to determine their drawdown and win/loss ratio. For example, if you execute 200 trades using the exact same methodology, by examining your data you could ascertain what percentage of your trades were winning trades. You could then determine the probability of a series of n trades being consecutive winners or losers. If you experienced winners, say, 60 percent of the time, you would have a 7.78 percent probability of experiencing five consecutive winning trades, versus 3.13 percent for five coin flips coming up consecutive winners. |
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As traders gain experience using a particular methodology, the amount they can risk will vary, because now they can begin to ascertain the amount they can risk on the basis of the probability of experiencing consecutive winners or losers. Conversely, beginning traders might think that they have a 50 percent probability of picking a winning trade. This is an illusion, because they are looking at the market with a methodology that they have no experience, confidence or, certainty in. In addition, after a series of losing trades their emotional makeup deteriorates so that they are more likely to choose a losing trade. |
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Equity to Be RiskedEquity Allocation |
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All traders are looking for a trading methodology that will rapidly and safely increase their equity curve. After all, it is the equity curve that every trader cares about. The challenge is that if the equity curve increases too slowly (even if it is a safe, smoothly increasing curve), traders become frustrated with how long it's taking to accomplish their goal. Yet if the equity curve increases too rapidly, the drawdowns will probably exceed their capital base, or make them very nervous traders. In other words, the faster the trader's equity increases, the more likely that drawdowns will be severe, and the slower the equity curve increases, the more probable that drawdowns will be moderate. |
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