Guest Commentary: Does Your System Have Positive Expectancy?
A viable system has a significant positive expectancy. Here are some guidelines in finding it.
What is a positive expectancy? It means that over time, the amount won exceeds the amount lost in trades. This doesn’t necessary mean having a system that wins most of the trades.
If your risk reward ratio is a healthy 1:3 or more, it means that when you can afford to have more losing trades than winning ones, as the winning ones will compensate for more than one loss.
Backtesting your system will provide you with the verdict. Yes, backtesting has limitations, and therefore we’ll add a few more rules to make the tests more serious:
- Pick 30 samples. This may sound like a lot of backtesting, yet it will provide more solid results. A minimum of 30 samples is a common rule of thumb in statistics.
- Take your samples from a period that exceeds one quarter. Patterns of trade change all the time. A system may work perfectly well during one quarter and totally fail afterwards. Spreading the tests over a longer period of time will provide better results.
- Count the pips: When you have all the backtests in place, put all the winning ones in one column in your excel sheet (or whichever tool you use) and the losing ones in another one. Also make a separate grand total of winning and losing pips.
- Make a ruling: If the winning pips are 55% or more of the grand total, you have a winner. If the winning pips are larger than the losing ones but their share is less than 55%, perhaps it’s worth a wider examination. If the losers exceed the winners, the system is questionable to say the least.
What do you think? How do you test a system?
Further reading: 5 Most Predictable Currency Pairs - Q1 2012
By Yohay Elam, Forex Crunch
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.