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The percent profitable fallacy - Why a large winning percentage means Little

June 1, 2004

 

A concerned customer called me towards the end of last month asking why her system doesn't take winning trades a higher percentage of the time. She equated a wining percentage of 50% as random action, and equated random action to unprofitable. "The system is just guessing which way the market will go", she surmised, "that's why it's winning percentage is no better than that of a coin flip."

Are we looking at the same system, I asked? Past performance is no guarantee of future results - I reminded him - but who cares How Often it makes money…the important part is that It Makes Money.

The sobering fact is that many investors have a need to be right, and are more interested in feeding that desire than actually making money in their investment. These are the people with bumper stickers reading: "Success is in the journey - not the destination".

I would argue that in investing - the bottom line, or destination, is more important. Someone who has to be right a high percentage of the time is someone who needs constant re-enforcement that they are an intelligent person. A good investment for this type of person has more to do with psychology than profits.

This is why many novice investors are drawn to option selling - they get to be right a high percentage of the time because the grand majority of options expire worthless. The options seller often makes money on nine out of ten trades, then loses everything he made on the 10th trade. The average loser is much larger than the average winner for an option seller profile, usually resulting in catastrophic losses.

Many of the more successful trading systems operate on completely different logic, and take on more of an option buyer profile. This profile sees higher average winners than average losers, but may only win 40% or 50% of the time. An option buyer will make relatively small bets, knowing full well they will lose more often than they will win in exchange for the chance of inordinately large gains on the winners.

The day trading systems below, including Compass, DayBreaker, and R-Mesa 5 are a good example, as each wins only about half the time - but average a good deal more on their winners than losers.

Long Term trend following systems such as Aberration and Andromeda are another example. Trend followers are designed to "survive" periods when the markets are not trending by stopping out numerous trades for small losses. This not only limits losses, but also insures you catch the next trend (by also getting you into all of the false breakouts).

It is interesting to note the large difference between Andromeda's 32.36% winning percentage and Daybreaker's 54.32% winning percentage. This would be disconcerting but for the fact that Andromeda has a much larger spread between its average winning trade and average losing trade, giving it the long option profile of few but large winning trades.

The lottery is a great (although extreme) example of an option buyers risk profile. You risk an insignificant amount ($1) on a ticket for the chance at $200 million, knowing your winning percentage is so far below 1% the odds of winning are 1 in a Billion or so. Also consider the lottery in "reverse" - where there is a very high wining percentage, like 99.9999999%. You would win $1 almost constantly, but at any time chance losing $200 Million. Would you play? I wouldn't.

The novice investor has a hard time comprehending that a system which loses on more than half of its trades makes money. Well, take a closer look. How does a system which wins on a large percentage of trades accomplish it? The system does so by risking a great deal more per trade. This keeps the system in more trades, allowing it to profit on more trades.

Imagine looking back over the past three trades on your system, and seeing that a $1,500 loss a week ago would have turned out to be a winner if the stop level had been just a ½ point further away. Adjusting the stop price that half point would have resulted in an extra trade in the win column versus the losing column, in turn causing the win percentage to tick up. The developer may then find another trade, where the stop only needed to be moved another ½ point, then another only ¼ point, and so on — creating a curve fit nightmare.

The risk averse system, on the other hand, will look at how much needed to be risked on the handful of runaway trades, and go from there. These systems will risk a lot less per trade, getting the system out of more trades while waiting for that one "runaway" trade.

It is mathematically difficult to develop a system which can have both a low risk per trade AND a high winning percentage, thus the reason you will rarely see a good trading system which has over a 60% win percentage. It's simply not worth the additional risk which must be taken on to increase the winning percentage.

It is quite simple to create a trading system with a high winning percentage. The rules to a system which wins on 100% of its trades is below:

Rule 1: Buy

Rule 2: Sell at Buy + 1

This system, by definition, will have a 100% winning percentage, as it only exits when profitable. This system probably makes a very, very attractive rate of return also. You better bring your checkbook for this one, however, as it has unlimited risk. Imagine taking the signal in March of 2000 on Nasdaq futures. You would still be watching your screen for that sell signal, your account would have lost approx. $400,000 (although not closed out the trade yet), and your glorious win percentage would still be intact.

People who have trouble with this concept are often victims of a societal system which teaches us that success and being right are one in the same thing. One can see from the above example how wrong that can be. The true lesson should be that it's ok to be wrong, just don't be wrong for long. In other words, cut those losses short.

In summary, each investor must look herself in the mirror and ask what is more important; being right or making money. If profit is the ultimate goal and not pumping the ego - then understand that a smaller losing percentage is not only ok, it is often a necessary step towards success.