What do the counts mean?
In Part 1a, we examined how to determine the likelihood that our exits will be hit. In that particular post, we posited looking at 100 setups, and I said that that was because it made the analysis simpler.
Our first order of business is to use our counts to determine the likelihood of our respective exits being hit. Let us use some example figures to illustrate how we would calculate those probabilities, and then later, the expectation/Expected Value for a trading method.
Without commenting on who they may be, I am sure you have at some time been told by someone, that you must “Always place your target 3 times the size of your stop and you will be OK.” You did it, with a nice tight stop, but things did not quite turn out “OK”, whatever that might mean, did they? I will ask you:
- Did you keep a record of what actually happened?
- If you did not, then how will you determine what really happened? Did you just hit a bad streak, or was the advice incomplete?
Anyhow, let us assume that posture, and use a stop of 5 ticks (a very popular one, from what many traders seem to claim), and, therefore, a target of 15 ticks.
Now we take our favorite entry signal, we go to the chart, and going backwards from the right side of the chart, we mark off each entry, counting and recording in each case, how many times that the stop was hit first, and how many times that the target was hit first. We stop after we have counted off 100 entries. Here is the likely result, but, right now, what matters is just that we have the records, not the actual values.
Oops, with such a tight stop, it turns out that the stop was hit 80 times, and the target 20 times. You did not realize that it was actually that skewed? Was it worse that you thought, or better? That promised 90% win-rate that the guru promised you does seem to be getting rather elusive, does it not? You have read the reality check, right? Well we had such small stops, that our nice 3 times larger targets kept us profitable. Did it? Are you sure?
Still what does it all mean? Per our count, we now know that historically, 80 times out of a 100, our stop was hit first. So that means that the fraction of times that the stop was hit first is 80 ÷ 100, or 0.8, or 80%. This then is what the historical recent data tells us is the likelihood that our stop will be hit first. Well, the definition of “percent” is “out of 100”, so we can say the likelihood of that happening, as measured historically, is 80%. By the same token, our historical data says that our target was hit first 20% of the time, or 20 times put of a hundred, or 0.2.
The likelihood of an event happening, is called “probability” by mathematicians, and that is the term that we shall use going forward.
Does this mean that going forward and forever into the future, we must and will always hit our stops first 80% of the time, and our targets first 20% of the time? No. All we can say is that statistically, that is what is likely to happen, not that it will happen. However, knowing these probabilities means that we can make objective decisions about out trades before we enter them.
In the next post in this series, we shall examine how to use the counts that we just made, to determine the probabilities of our various exits being hit first in our next trade, when we are examining an arbitrary number of setup instances instead of exactly 100.
In the meantime, if you found this useful, please leave a comment.