What Is A Good Trading Strategy?

At JF Lennon, we define a good trading strategy as one that gives positive “Expected Value” in one’s return after a meaningful number of trades over a time period.

Although it is possible to be on the winning side even if the probability of win is smaller than that of the loss, each win will have to be much larger than the loss.

Ideally the probability of win is preferred to be greater than that of the loss; the higher the winning probability the better. However, it is not reasonable to expect, in fact, improbable to achieve a 100% winning trades.

The term "Expected Value", also referred to as "Expectation", refers to the long-term average outcome of a given scenario. In order to calculate an Expected Value, you take every possible outcome, multiply each by the probability of that outcome taking place, and then adding those numbers altogether.

For instance, if you have a non-loaded, 6-sided dice, the probability of getting each of the values {1,2,3,4,5,6} is 1/6. Thus, after a large number of throws, the Expected Value is:

<Dice Value> = 1x1/6 + 2x1/6 + 3x1/6 + 4x1/6 + 5x1/6 + 6x1/6

                  = (1+2+3+4+5+6)/6

                  = 3.5

Applying this to Forex trading and assuming that for a given trading strategy, the Winning Probability is P_W and the Losing Probability is P_L, whereby P_W + P_L = 1, what is the Expected Value of return on trading?

For the sake of discussion, let’s further assume that both winning and losing trades are always 20 pips.

The Expected Value on the return on pips per trade over a large number of trades:

<Return on Pips per Trade> = P_W x 20 + P_L x (-20)

                                     = (P_W - P_L) x 20

Thus, it is clear that so long as (P_W - P_L) is positive, in the long run, one will have a positive return. In other words, one’s average wining pips per trade will be a positive number.

Of course, the larger P_W is compared to P_L, the better off one will be!

Let’s assume P_W = 0.70 (or 70% chance of winning), thus P_L = 0.30 (30% chance of losing for a particular trade):

<Return on Pips per Trade> = P_W x 20 + P_L x (-20)

                                      = 0.70 x 20 + 0.30 x (-20)

                                      = 8 pips

What this means is that if one is equipped with a trading strategy with the chances of winning being 70% and chances of losing being 30%, respectively, and the winning and losing pips are 20 pips for all trades, one can expect to win 8 pips/trade on average. BUT do not look down on these little 8 pips! In fact, this little equation

<Return on Pips per Trade> = P_W x 20 + P_L x (-20)

contains all the enchanting “Magic of Pips” and the secrets to accumulating wealth via Forex!

However, for the “Magic of Pips” to do its wonder, the trading strategy employed MUST rest on a strong foundation of 3Ms – Method, Mindset and Money Management:

1.       There must be a sound Method that gives one a positive edge, i.e. P_W > P_L, the larger the better

2.       One must possess a proper mindset, i.e. trading discipline and psychology

3.       Employ proper Money Management, which entails the proper position sizing based on one’s available trading capital

The above criteria are prerequisites for the “Magic of Pips” to do its wonder. If the 3Ms criteria are fulfilled, one is CERTAIN to accumulate wealth in the long run via the “Magic of Pips”!

Double-edged Pips

For illustrative purpose, for a standard contract of EUR/USD pair, 1 pip = $10

If one were to trade 1 standard contract each time, and have 20 trades per month, which is about 1 trade/day, what is one’s Expected Value in return?

It’s 20 x 8pips x $10 = $1,600!

This is guaranteed if all the assumptions encapsulated in the 3Ms criteria were met!

One might say, $1,600/month is mere peanuts, won’t get one anywhere…

Well, the assumption here is that one trades only 1 contract each time, what if one increases the number of contracts traded?

See the picture?

So, one might then ask why don’t we just trade 1,000 contracts from the outset?

One will have gained $1,600,000.00/month! Millionaire in a month’s time!!!

YES & NO!

The million-dollar question is what are the assumptions here? Were the 3Ms criteria still be adhered to in this case?

Even if given a sound trading system, would greed and fear creep in? Does one have the mental discipline to stick to the methodology religiously?

More importantly, what about money management? Does one have sufficient capital to withstand the drawdown due to losing trades? For in this case, out of 20 trades, we expect to have 6 losing trades. And however improbable, it is possible that all 6 losing trades come consecutively!

Scenario of 6 consecutive losses at 20pips/trade:

6 x 20pips x $10 x 1,000 contracts = $1,200,000.00!! (LOSSES!!!)

QUESTION:

Do you have $1.2 Million to lose?

Do you have a capital of $1.2 Million to begin with? Pips are double-edged things!

However, the “Magic of Pips” can still work its charm!

Equation of Wealth = Method + Mindset + Money Management

The “Equation of Wealth” remains sound, if and only if one adheres to a given set of rules of engagement in the Forex game!

At JF Lennon Institute of Financial Science, we’re committed to showing you the way, the scientific way to making the “Equation of Wealth” work for you by employing a good trading strategy.

Armed with the scientific method, one can surely
“Learn with Passion and Trade with Confidence!”