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.

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**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.

ryan says

HI Alvin,

It’s interesting that you share this. I just finished reading a bit about the work of Claude Shannon, colleague of John Kelly (that’s how Kelly value comes about). To cut the long story short: they studied information transmission, extended the study into gambling, took the model into Vegas, won at Blackjack table and extended it into portfolio theory. John Kelly’s work is an extension of what Shannon (dubbed the father of information technology) discovered. They set up hedge fund called Princeton-Newport and made 28% p.a. over quite a long period of time.

The link is not just an equity curve generator. It’s actually a ‘position sizing’ generator based on a given trading system. Based on 2 IRR and 50% chance, the Kelly value gives you a 0.25 reading which is very important. It tells you , you should only bet 25% of your capital, to be safe against elements of ‘bad luck’ and ‘bad streek’ over long period of time. That’s the Key element of Kelly’s Criterion. You will notice that the better the IRR value the higher the betting quantum Kelly value will suggest but it will not tell you to bet all into 1 basket. Read a book titled ‘Fortune’s Formula’ .

ryan says

Hi Alvin,

Thanks for sharing. And thanks Teck Wee.

Cheers.

Chemmie says

I have been trading fx for about a year now…and it’s getting no where….make lose make lose….the good thing is it’s just a small part of my portfolio…then bad part is that my capital did not grow in fact there is a small loss….the good thing is according to dr alexander elder if you only lose 10% of your capital in the first year you are on track…the bad thing is I am so sick of it that I have stopped trading for now…