Trading Rule #13 – Fooled By Numbers

I would like to start by acknowledging my fellow nerds. Those of you that once stared at the results of a backtest and said:

“I’m going to be rich, really rich”

Of course, then comes the crushing disappointment when you realize it was extremely curve-fitted and no way will it work in the future.

Good times.

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Anyway, it is very easy to be fooled with numbers. For example: Risk:Reward ratio

If you enter randomly on a limit order with a 1:1 risk to reward ratio, you will win 50% of the time. If you enter the market with a 9:1 Risk:Reward ratio (risking 9 to make 1), you will win 90% of the time. Both will be slightly less if you give up the spread and enter at market.

In chapter 12, we discussed “Signal Scope” – or “how far does this event typically move the market”. If your target is past that point, you are more likely to hit your stop. Playing with Risk:Reward may well give you a higher win rate, but that does not necessarily mean you’ll make more money.

Hence: Fooled by Numbers.

The biggest example of people being fooled by numbers is in the book “Trade Your Way To Financial Freedom” by Van K. Tharp, who explains an experiment with Tom Basso.

In it, they tested a “system” that “proved” you could make money by trading randomly.

• They entered the market on a coin toss.
• Used a trailing stop to exit.

The system was profitable. But those guys obviously did not have ADHD. If they did, it would have made their teeth itch.

Let’s have a think about what this strategy does. We enter the market. It doesn’t matter if we go long or short. We have a trailing stop loss order that will follow the market if it moves in the direction of the trade and will sit where it is when the market moves against us.

If the market is trending, then the losers will quickly get stopped out. On the other hand, the trailing stop ensures the winners will ride the trend.

Winners WILL be larger than the losers. That’s where the profit comes from.

So what is the problem? Why am I being such a Grinch?

The system worked because the market was trending. It is a trend following strategy.
It seems impressive because people assume the edge in a system is always in the entry. With this strategy, the edge is a combination of:

• Knowing when to turn it on.
• The exit strategy.

The trailing stop was the edge, in certain conditions.

I’m not sure if Van K Tharp and Tom Basso were yanking our chains or if they genuinely believed they could “Toss Their Way To Financial Freedom”.

So our lesson today is simple. The edge isn’t always where you think it is and playing with numbers beyond your signal scope might help your win rate but not your profitability.

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