Tek Wee sent me an interesting Equity Curve Random Generator. So what is this generator about? It is for you to calculate your profitability in the long run, with a specific risk reward ratio per trade. In other words, how many times can you be wrong, yet you can grow your capital continuously. I try to simplify as much as possible:
Fact number 1 – you do not need to be right on every stock/investment to be profitable. Yes, you can lose. But the next question is how much can you lose?
Risk Reward Ratio (RRR) – we know that we need to take risk to gain reward. To be a sensible trader/investor, you should be looking for at least 1:2 RRR. This would mean that you risk $1 to earn $2. For example, you buy a stock at $10, and you are willing to risk $1. You will sell if the stock goes to $9. For the upside, you are looking at $2 gain and will profit take when the stock price goes to $12. Hence, your RRR is 1:2.
Let’s say you always follow this RRR for every trade/investment you make. And you are only right 50% of the time. How sure are you that over 10 years, your account will end up higher than you started? Take a look at the chart, which I generated based on these parameters.
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
Performance for RRR 1:2 and win rate of 50%
If you start with $100 capital, you will end up with approximately $370 after you made 453 trades. Not bad for a RRR 1:2 and being right half the time! You should try to change some of the parameters yourself. There are 3 parameters for you to key in. First is the “win/loss” box, which is actually the RRR value. My win must be 2 times the size of my loss, hence win/loss = 2/1. Next is the “win prob” which refers to your win rate. In this example, I use 50% which is also 0.5. Lastly, it is the lines quantity, it is to randomize the test. Each line is a possibility of how your capital will move as you make your trades. Keep the “Kelly Val” and “Math Expect” unchanged. Once the parameters are set, press “generate”. You should press the “generate” button a few times to see if the graphs go up all the time. If there is an instance that any of the graph turns down, you should avoid this combination of RRR and win rate as there is a chance for you to lose money in the long run.
You need to be right at least 40% of the time for an RRR 1:2
Like I mentioned above, a trader/investor should seek at least for an RRR 1:2. I tried lowering the win rate as much as possible, before the graph becomes negative. I found that you need a win rate of 0.4 or 40% to be profitable over the long run. Take a look at the graphs below:
Thus, be forewarned. If you are risking $1 to potentially earn $1, you need to be right at least 60% of the time. Test your trading statistics with the generator and you know where you stand.