Last updated on August 20th, 2018
A trader decided to enter a position in a manner that was not consistent with his trading plan.
What he said was that he entered a trade based on the fact that as the market was already close to the stop the system had already calculated, it was worth the few ticks at risk to see if the trade would still work.
The stop was calculated because this was a trade that set up according to the trading plan rules but he happened to miss the entry.
I thought that entering a trading position when the original set up was underwater, was not the best decision.
- It would be easier for the market to move “just a few ticks” further than reversing to break even and then moving all the way to a point where at least something would be banked
- Market momentum would be against the signal at this point.
In fairness, the logic came from experience but until you take a look at the statistics, you can’t really know if it was a good or bad idea.
So that’s why I decided to take a look at what the outcome of a system would be for trades taken only a few ticks from the stop instead of the proper entry price.
Testing A Positive Expectancy Trading Strategy
I’ll start off by briefly outlining the premise without going into unnecessary details of the system. Basically, I took a decent enough plan and back-tested it to prove it had a positive expectancy. It didn’t set the world on fire but it was solid enough – probably better than what most are trading.
I then defined that to qualify for this different entry, it would have to get over 50% of the way from the strategy’s entry price to its stop price and it had to be within a set number of prices of the stop. These trades were then identified within the overall back-test as trades which had a certain relative MAE (Maximum Adverse Excursion).
There are going to be different systems with different results for this kind of test, although overall to some degree the original logic should hold and expectancy should drop compared with the proper entry for most trading strategies.
But the objective here was to choose a strategy which normally works well enough without cherry-picking it to illustrate my point.
The results were pretty clear in this case.
Around 80% of trades taken (over 200 trades in total) ended up losers. The otherwise solid system that showed itself to be a winning trading strategy overall, broke down using this alternative entry method.
Don’t Use Logic. Use Facts.
My point isn’t to tell you this works or that doesn’t work. In fact I’ve gone out of my way to be vague with the details for this very reason although the testing was thorough.
My point is to illustrate just how much a seemingly minor and even a potentially sensible adjustment to a trading system can have a drastic effect on its overall profitability.
You might well point out that in this particular case, had you taken the trade from the proper entry point, you’d have lost even more. That is true.
But you don’t know at that point that your trade is going to move that close to its stop price, whereas you do know if it’s already there.
My point is that in designing and testing a system you are working out all the details to put the odds in your favor over the long run. By changing aspects without having done further testing, how can you realistically expect to know what the effect will be on your system?
Don’t Discount The Psychological Challenges
What’s more is that there’s the potential for some serious psychological damage to be done at the same time.
Think for a minute.
The few times that the trade does reverse from close to the stop loss and goes to the profit target, you come away with a bigger profit than usual for a smaller risk.
Your ego grows as you have outsmarted the market and not only does the specific idea that you’ve tried get reinforced whether or not it’s a good one, but at the same time the appeal of breaking a well thought out plan get reinforced as you get rewarded for doing so.
The fact that you’ve had good experiences making these changes will act to encourage you to try again in the future.
But how many times does it take to see that these changes can work here and there but overall they won’t be profitable?
Don’t Tinker On The Fly
You should see that this was a great illustration of why changing the parameters of a plan during trading can be dangerous even when at first glance it might seem like a good idea.
You can never really tell on the next trade how it will end but if you have a tested a strategy thoroughly and genuinely have probabilities in your favor, you can be confident of making money over time.
If you don’t have a clue about what the odds might be, you’re leaving things to chance. Tinkering with your trade plan on-the-fly is something to avoid. The only way you should change your trading plan is after rigorous testing of the new variable you have included.