Setting up Profit Target of trading system depends upon CAR/MDD of strategy, account margin and your risk taking capacity. Its prudent to set a profit target based on facts and figures about the strategy, rather than a whimisical goal. Before we chose a scientific process for setting up profit target, it is important to understand uncertainities in trading which cannot be avoided at all. No matter how good the strategy we have, not matter how convinced we feel about the markets.
Understanding Probabilitues (Uncertainities) in Trading
We are risking time and money when we start trading. We don’t want to throw money at something that may not work, right? So, it is very important that we have a clear idea what do we expect in return for the risk we are taking. We do not need algorithms working on a super computer, but we need a clear business plan.
Let us have a detailed look at the risk-reward relationship which we use for trading decisions. We need to find answers for two fundamental questions:
- First, How much money CAN we make?
- Second, How can we optimize our returns, considering the risks we are taking?
To answer the first question, we will need to understand the profitability of our strategy from a reasonable mind.
To answer the second question, we will use some intuitive math.
Say we backtest a strategy which makes 60% profitable trades. We use this data to assume that the strategy has a 60% win rate.
Now say, you start trading this strategy. How many winners will you get in the next 100 trades?
Most people assume that 60 out of 100 trades will be profitable.
This is a dangerous assumption to start trading the strategy. Please remember, we are working in probabilities and not certainties.
Even if the strategy has a win rate of 60%, there could be only 40 winners in the next 100 trades. It could make you feel that the backtest was wrong, or the strategy stopped working.
Or there could be 80% winners in the next 100 trades, and you may start feeling super-successful.
To understand this uncertainity practically, we can experiment by tossing a coin. You can toss a unbiased coin for 10 times. You will find that it shows head 8 times, or even 4 times. The number of heads differ every time you toss it 10 times. We cannot avoid this uncertainty. Similarly, a strategy with 60% win rate, can give you only 40 winning trades out of 100. That could be awful, right? You need a business plan in place to handle such uncertainity. If the business plan does not take care of this uncertainty, we have very little chance of being a successful trader.
Estimating Profit Target
To quickly visualize the performance of a strategy, we use equity curve. The equity curve shows how a trading account’s cash varies over time. If you are making money, your equity curve goes up. When you are losing money, the equity curve goes downwards. It is a very useful tool to see how the account margin goes up and down by regularly trading a strategy.
A drawdown is the maximum loss that a strategy makes in its equity curve.
The drawdown shows the maximum amount of money you can lose.
Similarly, the duration of drawdown shows for how much time the strategy will remain under loss.
The maximum duration of drawdown for this nice-looking strategy is 4 months in backtesting. It could be even worse in actual trading.
You can reject this strategy if you are not comfortable with such drawdown duration and value.
If your financials plans support taking the risk, you can go ahead and deploy this strategy.
CAR/MDD, which means Compounded Annual Return divided by Maximum Drawdown, shows the average annual profit a strategy can make with respect to its worst drawdown.
We are trying to answer the question- How much money can we make?
You may have also noticed,
that most people talks about profitability in terms of absolute percentage only. This is unfortunate. Absolute returns by itself have no meaning at all, because the risk is being ignored. If your strategy makes (historically)25% profit on 1x leverage, it can make 330% profit by using 10x leverage.
We therefore use the metric CAR/MDD. It measures the percentage annual growth divided by the maximum drawdown.
A CAR/MDD more than 3.0 is considered good enough. It implies that whatever the money we plan to make, we are risking 1/3 of it. So, you can make only as much money as your risk capacity and CAR/MDD of your strategy allows.
The amount of money which we can make, depends upon the CAR/MDD of strategy, the account margin, and our risk-taking capacity.
Now we come to the second and most important question- How can we optimize the returns, considering the risks we are taking? How to setup profit target for the trading system?
The answer is-
By trading multiple uncorrelated strategies.
Even if you have 5 uncorrelated strategies with poor CAR/MDD of 1.2, the portfolio CAR/MDD can rise above 5!
It does not require rocket science to generate uncorrelated strategies. Say you have a trading logic, for example a Crossover of MACD with Signal like, which you are using for trading. This is a very simple example. All of you might have experimented with the MACD.
You can trade the same logic on different time frames, like 3-minute and 60-minute. When the 3-minute time frame is trending, the 60-minute time frame could be range bound. Price patterns in 3-minute time frame are totally independent of price patterns in a large time frame such as 60-minute. Using Amibroker, it is easy to trade multiple timeframes at the same time fully automatically.
You can also trade the same logic on uncorrelated instruments, for example share of a blue-chip and crude-oil futures. Currency, commodity and many sectors in stock market are uncorrelated in short-term. As per this example, you can have 4 set of uncorrelated strategies. First, 3-min time frame on a bluchip, second 60-min time frame on blue-chip; third, 3-min time frame on crude-oil future; and fourth, 60-min time frame on crude-oil future.