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Are You Using the “Trader’s Equation?”
01/17/2012 9:45 am EST
A trade is not worth taking unless it satisfies the "trader’s equation," explains Al Brooks, who defines this critical calculation and recommends examining it prior to executing any trade.
My guest today is Al Brooks, and we are talking about watching the market in mathematical terms to make your trading decisions. So Al, what are the basic concepts of mathematical terms in the market?
The most fundamental piece of mathematics that everyone uses when they are making a trade is the “trader’s equation.” They are thinking, “What is the probability that this trade will work?”
Let’s say the probability is 60%; that means the probability that it will not work is 40%.
So you take the probability of success and you multiply that times how much reward you stand to gain; i.e. where is your profit target, how many ticks away? That number has to be greater than the probability of failure times the distance to your stop (your risk).
So the probability of success times the reward has to be greater than the probability of failure times your success. If you don’t have that, you should not take the trade.
So you are calculating this on every trade you take?
I don’t sit down and pencil it out, but I have an approach that I use.
I consider 40 trades a day, and I take ten to 20 of them. What I do is I have to consider risk, reward, and probability. I know what the risk is; I know where I am placing my stop. I know what the reward is; I know how far away my profit-taking limit order is. What I don’t know is probability.
If I think the trade will probably work, in my mind, I can’t have that belief unless the probability is at least 60%, so if I look at a trade and I say, “Yeah, that looks like a good trade,” I assume the probability is 60%.
So if I have a 60% probability, what is the minimum reward that I need to have a positive trader’s equation? The reward has to be at least as large as my stop. So if I have a trade that is likely to work, I will make sure that I set my reward to at least as large as my stop.
If I look at a trade and I say, “That might work, it might not work,” then I assume the probability is 50%. What size reward do I need with a 50% probability to make the trade profitable? I need a reward, in general, that is about twice the size of my risk.
So if I look at a trade and I say it might work, 50% probability, I can only take the trade if I am going for a profit target that is at least twice the size of my risk. So if my stop has to be two points away, I have to go for at least four points, and if I think four points is unrealistic, I can’t take the trade.
Are you putting those stop losses and profit targets into the system so it automatically gets hit whichever way it goes?
Right, as soon as I take a trade, my broker’s software immediately creates a bracket order. For example, if I am buying and I am trading the E-mini, on an average day, the bracket order might have a two-point stop and I create a default, a limit profit-taking order two points away.
So on most of my trades, that is what I do; a two-point stop and a two-point profit target. Both protect me. The stop protects me, obviously, if the market starts to go against me, and the limit order protects me if the market goes my way and then goes against me. If I have a limit order, I know that I get out with a mathematical profit.