I see many traders especially, the new ones obsessed with accuracy. They are always hunting for the trading system with higher accuracy. The Internet is full of sellers who are selling trading systems, software which actually do not work and they claim to have very higher accuracy. Many tips sellers also claim to have 90% accuracy.
You don’t need higher accuracy to make good money trading in stock, commodity or currency market. If you read about the great traders like Gorge Soros, Jesse Livermore, Deniss Richard, Paul Tudor etc you will know that they all had very poor accuracy. They all made a huge money just with an accuracy of around 40%. It doesn’t matter at all how many of your traders goes right,how much accuracy you have. What matters is that how much big profit you make when your trade is right and how much less you lose when your trade is wrong. Accuracy is just a rubbish thing. A trader with an accuracy of 40% can make more money than traders with an accuracy of 90%.
Let’s understand mathematically how a low winning rate trading system can make more money than the high winning rate trading system. The earning power of any trading system can be calculated as
E = (W x AW) – ( Lx AL)
E= Earning Power
W= Wining Rate
AW = Average winner
L = Losing rate
AL = Average loser
Let’s take a trading system with 50% winning rate. Now, assume average profit on winning trade is Rs 500 and the average loss on losing trade is 350 Rs. Then the earning power of the system will be
E= (50% x 500)- (50% x 350)
E = 250 – 175 = 75 Rs
That means this system will give average profit of 75 Rs per trade
Let’s take another trading system with an accuracy of 40%. Average profit winning trade is 1000 Rs and average loss is 350 Rs Then earning power per trade will be
E = (40% x 1000) – (60% x 350)
E = 400 – 210 = 190 Rs
This trading system will earn 190 Rs per trade that 2.5 times more than that of the first system even though it has much lower accuracy. It’s clear that lower accuracy doesn’t matter when the average profit per trade is higher.
Your risk and the reward is the important thing. All the great traders of the world had lower accuracy. They had more losing trade than winning trade. But they did well because their winning trades produced bigger profits. Bigger profits per trade don’t come from short term trading. All the traders who made their fortune from the market held their position for long and none of them was a day trader.
If your profits are large you don’t need great accuracy. What matters is risk reward ratio. You can read more about how a better risk-reward ratio can maximize your profits.
|Risk Reward Ratio||Required Accuracy Rate|
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.