How to Create a Profitable Trading System
Create a trading system with a positive expected value.
The expected value of your trading plan is how much you will gain or lose based on the statistics. Expected value is calculated by multiplying the probability of being right by the reward and subtracting the reward from the probability of being wrong by the loss.
Expected value = Probability (correct) * Reward (correct)-Probability (incorrect) * Loss (incorrect)
To calculate the expected value of a trading system, you need to know the probability of profit and the expected reward potential. Additionally, you need to know the probability of losing and the potential for losing.
First, you need to have a risk management system in place to base the size of your wins and losses. Let’s say you will limit the size of the loss to $200 and the size of the gain will be $60. The rate of return for a strategy with this risk-reward is 76.7%, meaning you need to win more than 76.7% of your trades to make money.
Now you need to backtest a trading system who wins more than 76.7% of the time. Strategies like this are best used with options since the profit probabilities are given when entering the trade. If you sell put options on a stock index with a delta of 0.15, you should earn about 85% of your trades over time.
However, the option delta is the percentage chance that an option will be ITM at expiration. If you take profits and manage them before expiration, this number will make less sense. You need to perform a backtest and know how often you will take profit against a stop loss. If you make a profit on at least 77% of your trades, you will at least break even in this example.
The amount of money you make or lose in the stock market is a simple statistic. You need to create a positive expectancy system based on success rate and risk-reward.
If you skew the stats in your favor, you are bound to make a profit on many trading events. Options are advantageous for statistical traders since the profit probabilities are generated by the Black-Scholes model.