To be successful, a trading system must have a profit factor of more than 1.28 over 1000 trades for trading capital of at least $100,000.
Profit factor = Gross profit divided by Gross loss
Therefore, Profit factor is a rough estimate of positive expectancy
Take for example a coin flip. If you were to take a coin flip over 1000 flips, the profit factor would be close to 1.0.
two words: [B]Oppurtunity Cost [/B]and [B]Risk premium[/B]
In order to justify its existence, a trading system has to make more money than simply investing it somewhere else.
In order to justify the risk a trading system poses to a trader, the system has to make more money than other lower risk approaches.
- Studies by Eugene Fama have a shown that a simple passive low risk buy and hold strategy for stocks with low PE ratios yields an annualised return of 20.1 % over the course of 60 years after inflation. Thats a profit factor of 1.201
Therefore, a trading strategy has to have returns above at least 1.201 in order to justify the increased transaction costs and increased risk. There is no point in trading if you can get higher returns anyway from not doing much.
Additionally, there is an average 3% inflation rate per year. This means that the system must have a profit factor of 1.231, to compensate for the inflation per year.
Also, there must be a [B]risk premium[/B]. This is the reward for taking on additional risk. I’m sure many people would agree that there is really no point in taking additional risk for a one or two increased percentage points of return.
Risk premium is more difficult to calculate.
I like to use time oppurtunity cost to calculate the risk premium. How much time are you spending with an active trading system?
Then multiply that time with the minimum wage, which is currently $20 in higher wage countries like Australia. You have to calculate the time you have sacrificed for forex as compared with simply working in a mall somewhere.
For example, if a system takes one hour per day on average to manage, that is 250 x 20 = $5000. The system must make AT LEAST $5000 in addition to the profit factor of 1.2301.
Assuming you are rich and started out with capital of $100,000, that would put your required profit factor up 1.28.
If you are like the majority of traders out there who don’t have such an amount of capital to start trading forex, your profit factor has to be far higher. For example, if you started with $10,000, your profit factor has to be 1.73!!!
Furthermore, a one hour per day trading system is considered fairly “set it and leave it”. Most systems are far more intense, and my require full time trading, possibly 8 hours per day. If it was 8 hours per day, your profit factor has to be a near impossible sounding 4.23 to justify the cost!!!
Make sure you start with at least $100,000, otherwise you would need an impossibly powerful trading system akin to a holy grail
Go for trading systems that take up the least time, or employ algorithmic/robot trading. With algorithmic trading, you can pretty much abolish the risk premium factor in your calculations, but be careful.
Adequately backtest your system and make sure it has a profit factor of at least 1.23 + risk premium over 1000 trades.
Now do you see how daunting the prospects are??
This post is also the reply I was preparing for the 3 individuals who accepted my challenge: namely master tang, simbafx and I think Matt. The above explains the parameters of success which I promised to take some time to prepare. Also, you are allowed to use position sizing at 2% risk to the capital.
For those who are unaware, the older thread concerns the impossibility of trading forex successfully BECAUSE of the above. I think a better way to phrase it is “impossible for trading to offer additional returns”, which in effect, would means its pointless. Granted, I was open to suggestions otherwise, and the 3 gutsy indivduals above accepted my challenge.
But to date, there have been no trading systems with a positive profit factor. Its pure gambling.
This was the reason for my bleak original thread, which was, in my opinion, unjusitifiably closed. I apologise for not putting this post on sooner, as this would have explained my position thoroughly. I simply want to share some insights, but I came across a bit harsh. You see, back from where I come from, we like taking a piss at each other.