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The Win Rate Fallacy

The Win Rate Fallacy

My 8-year-son, who is probably a lot like your 8-year-old son, is always asking why. Sometimes it’s a little annoying. Like if I’m climbing into bed with the latest episode of Stranger Things and he asks why the black hole they just discovered in the Milky Way is so big.

But most of the time, it’s actually pretty cool. Mainly because it reminds me that I’m not asking why enough myself. Which really means I’m not being curious enough.

This isn’t just dad stuff. It’s actually relevant to all of us.

As professional traders, when we’re not curious about our own trading behavior—when we’re not asking why—we get lazy. And laziness, folks, is as bad for trading as the guy in the Peloton ad is for healthy, constructive marriages.

So today we’re going to ask why.

Why is it that you can win and lose at the same time when you’re algotrading?

If this is the first time you’re hearing this, even if you’re chilling out with the latest Stranger Things, the 2Ring Algo Team strongly recommends you close Netflix right now and listen up because this next part may blow you mind.

 

Yes, it’s true. Winning may be hurting you.

Ever had an algotrader friend come up to you and show you his win percentages with a big smile on his face like he’s about to go out and buy a Ducati Scrambler with all his extra pocket money?

That’s probably because he fell into the trap of thinking that having a high win percentage means having a winning trading strategy.

 

As professional traders, when we’re not curious about our own trading behavior—when we’re not asking why—we get lazy.

 

And, just to make this absolutely clear, we are NOT saying that a high win percentage is a bad thing, any more than winning the lottery more than once is a bad thing.

What we are saying is that your high win percentage doesn’t necessarily indicate that you’ve built a profitable trading system.

And that is a key distinction to make, because it’s the profitable trading system you need to buy that Ducati, not the high percentage.

If my son was sitting here with me, this is the point where he’d be asking his favorite question: why?

Why can you have more losing trades than winners and still be profitable?

That’s actually simple. Because by themselves win and loss percentages mean nothing. You need to consider average win and average loss per trade to really have a clue if your strategy has paid off.

In fact, you should actually be focusing on something called expectancy, because this is your ticket to building winning algos.

Here’s how it works.

 

Expectancy in action

When you’re thinking up algos to test, you should always backtest, the longer the time period the better.

Let’s say the strategy you’re testing has an 80% win rate. That’s pretty high. But its average win (AVG WIN) is €300 and its average loss (AVG LOSS) is a whopping €1500.

This is where we get our expectancy per trade, which in this case would be -€60.

 

Here’s how we calculate expectancy:

Expectancy = (Win Percentage * Average Win) – (Loss Percentage * Average Loss).

Even your Ducati-riding friend would agree: your 80% winning system is designed to fail to the tune of €60 per trade.

Now let’s turn that around and look at a trading strategy that on face value doesn’t seem like much at all.

We’re going to give our second algo a wimpy-looking 20% win rate with an average of win of €1500 and an average loss of €300.

That do-nothing trade will actually earn you €60 per trade.

Magic?

Nope. That’s just the numbers.

 

By themselves win and loss percentages mean nothing. You need to consider average win and average loss per trade to really have a clue if your strategy has paid off.

 

Now which one do you like? A high win percentage that’s costing you €60 a trade or a loser that’s earning you €60?

I think even my 8-year-old son would be able to answer that correctly. He’d also ask you his favorite question if you told him you prefer the high win percentage.

Why?  

 


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