Saturday, January 28, 2012

What Edge Do You Need?

I have been spending a bit of time pondering the risk-of-ruin (or as I will call it Probability Of Ruin so as not to confuse acronyms with return-on-risk) equation:
PR=((1-Edge)/(1+Edge))^RiskUnits

PR is a number between 0 and 1, where 1 is a virtual certainty and 0 is never-gonna- happen. Given the proper inputs, PR tells you what the probability is of blowing-out your account. You want to shoot for a PR under .1 and more ideally around .01-.02. That is to say if your PR is getting above 10% you need to reduce your trading size and if it is below 1% you are not earning as much as you might and should consider increasing your trading size.

When I was an InvesTools student I was taught not to risk more than 2% of account value on a trade. So this means that my RiskUnits are 50. Arbitrarily using .01 for the probability for PR, this morning's exercise is to work out what sort of trading Edge I need to stay out of trouble. Although, it is not possible to solve the PR equation explicitly for Edge, my son has introduced me to a website called Wolfram Alpha that can do an heuristic calculation based on these inputs without much fuss. The result I obtain is .046 or about 5%. 

Check it out!

So what does Edge mean?

(TBC)




1 comment:

  1. Hi - I'm enjoying reading your (defunct?) site http://www.smalldoginvestor.com. I'm a theoretical physicist who's learning about trading on short-term (intraday, swing, weekly, etc.) fluctuations of securities and derivatives. I don't know much yet -- I've been paper trading with TOS just to get the mechanics down and will continue this way until I get fluent in the platform and develop some metrics and strategies of my own.

    In any case, I'm enjoying reading your weblog since it's very much along the lines of what I've been looking for -- just a regular person writing about trading strategies, etc. It's a welcome alternative to the BUY MY TRADING STRATEGY NOW!!! scammer nonsense.

    The reason I'm writing is in reference to your comment above that "it is not possible to solve the PR equation explicitly for Edge." It can, actually, be done. Here's the solution:

    E = (1-p^(1/Nt))/(1+p^(1/Nt))


    Here, E = Edge = 0.0460, p = PR = 0.01, and Nt = RiskUnits = 50.

    I haven't yet researched what exactly 'Edge' is -- I'm guessing that it's the bias away from 50% in performance (correct bets/all bets) -- so you have to be right about 55% in your guess on a given initial and final transaction targets.

    Looking forward to reading more of your site. If you'd be interesting in corresponding that would be of great benefit to me. (But probably just time consuming for you.) Thanks.

    Mark

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