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)




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