Trading with Expectation/Expected Value – Part 3a: Find the Target before you enter the trade

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Do we really have to use fixed Targets and Stop Losses?

Up until now, while discussing how to trade by using Expected Value, we have been looking at making our statistical analysis with a trading method that uses a consistent fixed number of ticks for a Stop Loss and a fixed number of ticks for a Target, then using the collected data to determine the probability of hitting those prices, and from that calculating our Expected Values and ratios.

As a refresher, here are all the links again:

That is often the way that traders look at analyzing a trading method, if they do so at all. Given that, what if we turned the question around and instead of asking how often a specified “number of ticks” target was hit using our method, we instead asked: “Where should I have put my target so that, given the last specified number of instances of my setup, my target would have been hit at a specified percentage?” To put some example numbers:

“Where should I have put my target, so that in the last 34 instances of my setup, my target would have been hit 60% of the time before my Stop Loss was hit?”

If you could use your records to determine beforehand that in the recent past, by measuring every upswing, 60% of those swings contained 50 ticks or more, would you think that would give you a good idea where to place a target, with a good chance that the target would be hit?

Gathering the Statistics

In order to answer that question, we shall have to gather the necessary statistics for analysis. We essentially use the same process that we used to get the statistics in Part 1 of this series. The difference is that, for every instance of our setup, we do not just have to look at some static values for Stop Loss order and Target order to see which was hit first. Instead we have to:

  1. Decide on criteria which determine the furthest travel of price for and against us.
  2. Record all those prices, and hence the price travel after entry, both for and against us.
  3. Use the price travel numbers to create a probability density function.
  4. Then use that to calculate what price travel provides the answer to our question above.

To remind us of the question, it is: “Where should I have put my target, so that in the last 34 instances of my setup, my target would have been hit 60% of the time before my Stop Loss was hit?”

After we do this for the Target, we do exactly the same for the Stop Loss.

At this point, we now have a value for the target travel and the Stop Loss travel, and their associated probabilities, as specified by our trading method, so we can calculate an Expected Value Ratio, and proceed with validating our trade, the next time it sets up.

In effect, what we are doing is running a continuous backtest every time we get a trade setup, and then using those statistics to qualify our trade.

Instead of running a backtest over some fixed period, we are now running our backtest in a sliding window that encompasses the last 34 (that is what we specified above) instances. Our time period for the backtest is flexible, because we are examining instances of our setup, not just some arbitrary length of lookback time.

We know how we shall approach the market. What next?

In our post The Basics for a successful trading method, we stipulated that “the first stage in trying to build a trading method is to ask yourself how you intend to approach the market.” In the previous post, How do you talk to the market? – Do you demand or do you ask? and this post, we have answered that question:

we shall ask the market what it is willing to give, not try to tell the market what we want to get!

Next we shall look at a chart to see if we can find a consistent price behavior of which we can seek to take advantage. That is the second requirement listed in The Basics for a successful trading method.

We welcome your comments, and any questions that you may have.

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