Line Your Own Pockets

Michael: 00:00

Hello, everyone. Welcome to another episode of Line Your Own Pockets. Last episode, we promised, so we're delivering on that promise, that we talk about all of the different things that you could optimize for and what to potentially optimize for. So if you missed last episode, we were taking some user questions about kind of optimizing long versus short setups in in different ways. And we just, the moment, said, well, this will be a really good one for next time.

Michael: 00:28

So this is next time. This is what we're doing. So, you know, I know we talked about this a little bit a long time ago, but hopefully we're a little better at this now. And we said, I think you said, oh, we should go back and listen to the last time we talked about this. And I said, absolutely not.

Michael: 00:46

I will not. I, A, I hate listening to myself talk in general, but B, I went, I think back to one of our first episodes once and I got five minutes in and I just could not take it. I'm glad that we're... We've gotten better over time, I think.

Dave: 01:03

Okay. So first thing I want to say is I got to get something off my chest. So this morning, I forgot to start Amabroker for my trade. So so sometimes, you know, I get distracted, you know, 09:30 comes around. Sometimes I forget to bring up a platform.

Dave: 01:28

You know, I'm just doing other stuff. Mhmm. And, of course, I go in. I'm a little too late. I look.

Dave: 01:35

There's no trades coming in. And then I go back and I... I've got a way to do, like, a sort of a real time back test now to see what would have matched.

Michael: 01:46

I see this trade that

Dave: 01:47

I should have been in. So so this really pisses me off when this happens. Right? I got

Michael: 01:56

Mhmm. And it should regardless of whether the trade is good or bad. I think that's another thing. Like, even if you Yeah. You know, the the trade would have lost you a grand, you should still be mad even though you're a thousand dollars richer that you didn't do it.

Dave: 02:10

Yeah. Yeah. That's... Yeah. Very true.

Dave: 02:12

So, you know, I don't automate completely everything. Although, with this, I should. And so here's here's how I'm gonna tackle it. I just wanna... It it struck me as something that could help the audience because because here's exactly what I'm gonna do.

Dave: 02:31

And this is concept that I learned at TradeEdit, which is really a good concept. So to to fix this, what I'm gonna do... Like, one one way you would... Might wanna fix fix this is, like, just set a reminder for yourself. Right?

Dave: 02:46

But the thing about reminders is they pretty quickly go into the background. You you kinda quickly become desensitized to it.

Michael: 02:58

You just hit stop and you you... Your brain just doesn't process that you should be doing something.

Dave: 03:03

So what I'm gonna do here is, is I'm gonna use what I call... What's called a dead man timer. And it's it's a much better approach for something like this. So think about, like, like, you wanted to notify... Like, there's several different ways to notify.

Dave: 03:25

You could just have a a sort of a dumb notification that goes off at a certain time. You could you could notify when there's a problem. Right? You could have some logic to do that. Both both of those ways are inferior to this dead man timer.

Dave: 03:41

The dead man timer is a great way to do this because it's only gonna notify you when it doesn't see something happen. So what I'm gonna set up is my ammo broker script is gonna be pinging this service. Like, basically, pinging this dead nine timer. And this service that I use called BetterStack, you can set up what are called heartbeats. If this heartbeat isn't pinged in a certain amount of time, I get a high priority notification.

Dave: 04:16

Like, and this gonna... And you can set it up where your phone will go berserk until you do something about it.

Michael: 04:25

Oh, yeah. I've seen that feature in iPhones where it's like the normal notification and the obnoxious notification. Yeah. If... Yeah.

Dave: 04:32

So the the thing that makes this very good is you have this external service that's yours... That that is actually monitoring it. And that's good because, like, let's say your notification... Like, you got a problem in your code and your code doesn't run. Like, well, you're not gonna give them a notification if you don't have a dead man timer set up.

Michael: 04:55

So... I like that because my my initial thing was, like, we'll just set up a Claude scheduled task, but the... That Right. Also lives on the same on the same server. Right?

Michael: 05:05

So... Or on the same computer. So if something's wrong from, like, a, like, a hardware level, then just both of them fail at the same time.

Dave: 05:13

Right. And what if you're out of tokens?

Michael: 05:16

Mhmm.

Dave: 05:17

Right? Then then the notification isn't gonna happen. So this is the right way to do it. And I learned this a long time ago from somebody at Trade Ideas. And it's it's...

Dave: 05:26

It comes in handy so many times. So it's definitely the right way to do it, and it just solves so many problems. And I've, you know, I've I've tried to solve them in different ways over the years, doing these things that... Like, I remember we had a a notification at Trade Ideas. There was some logic there to produce the alert, but then the whole...

Dave: 05:48

Like, all the DNS went down, so it wasn't running at all, and nobody knew. So I think this solves that problem. So it's just a really I'm I'm sure there's some listeners that will be able to use this in some scenarios. It's just... It's such an important concept, when you have mission critical stuff that you rely on, like trading.

Michael: 06:09

Well, so I have to ask, why don't you automate the launching and and everything of this? Why do you decide to be there? Like.

Dave: 06:20

Yeah. So just because I haven't gotten around to it is basically the cheap lazy answer. But, you know

Michael: 06:30

Because because I think the ultimate goal should be... And then as morbid as it sounds, I'm trying to do the same thing with my business and with my trading. I I could be dead, and everything hopefully should still operate for another couple weeks anyway until someone gets along, you know, comes around to to kind of shut everything down. And again, as I think probably a better way to word that would be a vacation. But, you know, it should be the the function that you're you're looking for at the end of the day is is you can be completely removed from the equation.

Michael: 07:02

And for some amount of time, things will continue to kind of tick along without you.

Dave: 07:08

Yeah. And... Yes. So there is a phase I go through when I get stuff off the ground where I do want... Like, it's not fully automated right from the gun a lot of times because I wanna see the process.

Dave: 07:21

I wanna know... Understand every part of the process. I wanna, you know so, yeah, the the... This will be... This final step will be completely automated real soon.

Dave: 07:35

So...

Michael: 07:35

And and the last thing before we get into it, you didn't tell us what what would the trade have done. Was it a good a good one?

Dave: 07:43

Was a good trade. Yeah. It was a good trade, which is extra motivation. Yeah. But your point is very well taken about if it was a losing trade still.

Michael: 07:52

Right. You still have to you still have to... But you can't avoid that emotion of of, you know, there'd be a certain amount of relief whether you you want it to be or not if it was a, you know, a catastrophic loser that you just dodged. But yeah, you should look at it the same as still because that particular trade is is irrelevant. Right?

Michael: 08:12

It's the fact that, you know, you should have been should have been good to go there. Yeah. Alright. So well, that's... Jeez, we already answered the first thing.

Michael: 08:21

One thing to optimize for would just be, automation or, I guess, time spent or or human involvement needed. That could be one thing that we we talk about right off the bat, and it's a good thing to to look at.

Dave: 08:34

Yeah. So the other thing I was thinking about is this other kind of analogy. Well, I thought of a couple different analogies for this. So I was... Oftentimes, before we record, I'll go down and get a glass of water.

Dave: 08:49

Mhmm. And I I... There's a little water spigot in the fridge, which I use. And it reminded me of the fact that I really love leftovers. And my wife...

Dave: 09:03

I had to sort of teach her the value of leftovers. And I... So I have this sort of a protocol for leftovers, something I, quote, unquote, optimize on. So I have, the protocol is FIFO. First in, first out.

Dave: 09:26

So I had to sort of teach my wife about this and why it's a good system to have. You know, she wants to sometimes eat the most recent thing that we've cooked and put in the fridge.

Michael: 09:39

Mhmm.

Dave: 09:39

But I'm like, no. No. No. Let's eat. The first thing we put in, the oldest thing.

Michael: 09:45

So Dan, it's probably way environmentally friendly of yours.

Dave: 09:51

My my system for eating leftovers is FIFO. Like, that was... That's what I'm optimizing So the other analogy I have for this is when we started this podcast, you know, when you when you start a podcast, if you go and, like, just do a search for, like, how to start a podcast

Michael: 10:14

Mhmm.

Dave: 10:15

There's a whole bunch of stuff that you don't need to do. Like, we don't have artwork for the each episode. We don't have a stupid jingle that people listen to when we start the the show or something.

Michael: 10:29

You're saying you don't want me to sing... Start singling... Singing a jingle before... I'll do it. I mean...

Michael: 10:33

But there's

Dave: 10:34

there's all sorts of things that you don't have to do. Mhmm. And but if you go and search, people are gonna say, like, if you go ask Claude, Claude's probably gonna tell you to do some of these things. Right? The other thing that we don't do is we hardly ever edit anything on the podcast, which is...

Dave: 10:56

That's so... I mean, every once in a while we do, but but I think I think it's gotta be way less than other podcasts. And we set out that out from the beginning to try to do that just because that's a rabbit hole that you will never get out of if you... You know, we wanted to get rid of every or every pause or whatever or every stupid thing I say. Yeah.

Dave: 11:19

We we would never get out of it. So we just we are optimizing for, like, as little effort as possible to try to deliver as much value as we can with this.

Michael: 11:30

Well, as much as I was, you know, I was joking with your your automation thing, I do think that is key before we get into, you know, metrics and Sharpe ratios and and blah blah. You know, the optimizing for life, I think, is is a good thing. The amount of people that I talk about or I talk to and I'm like, okay, why are you interested in trading? The number one answer is usually just, like, freedom. And then you talk to them, and if these are discretionary traders, they're like, okay.

Michael: 11:57

So I get up at five every morning, and I sit at a desk in front of five monitors. And then I I sneak out for a pee for, like, two seconds at noon, and then I'm back in for know, when this company reports earnings. And and, you know, these guys are working ten, twelve hours a day. And I'm like, well, for a a non guaranteed income, like, man, if you just became, like, a lawyer or a doctor, you'd you'd you'd probably be working the same ridiculous hours, probably making more money and definitely way more secure, in what you're doing. So it...

Michael: 12:29

Yeah. It makes total sense. You wanna optimize for least needed touch. Now we talk about this all the time where it, you know, automated or systematic trading doesn't mean you just go to the beach and do whatever. You you have to work and build new systems and test and refine and and blah blah.

Michael: 12:45

But that should be your decision on when and kinda how much to do it. And if you find that you're like constantly having to be glued and, you know, you're not optimizing for that kind of automation layer, then I think you're you're really missing out. I think that's one of the first things to look at is can you optimize for for doing a little bit less and making the same amount? Or I say in a lot of cases, probably way more money.

Dave: 13:13

Yeah. That's true. So, I mean, one thing that strikes me here is there's a lot of things you can optimize on.

Michael: 13:22

Mhmm.

Dave: 13:23

And they're very different things. So, yeah, let's let's jump right into it with... Here several minutes into the podcast. But Mhmm. Yeah.

Dave: 13:36

There are lots of different metrics you can use to to optimize on. And I think it's important to think through those and make sure you're optimizing on the right thing. And you're probably going to have different traders using different ones. But I think, ultimately ultimately, the right one to use or the one I have tend to use is looking at the equity curve. Mhmm.

Dave: 14:09

And there's some... There's actually a little bit... There's quite a bit of discretion there when I'm deciding what I want to apply.

Michael: 14:17

So let's first go into the, I don't know, the common things that people use that we don't. And the one that I like to crap on the most is Sharpe ratio, which I think is just the biggest load of crap ever. And... But it's it's funny because these are the things that if you if you Google or if you, you know, talk to mathematicians or economists or something, they'll talk about a lot of these ratios. And this...

Michael: 14:43

These are the ratios that matter. And in a way, think it's it's lazy. Oh, that might not be the right word, but it's it's simple, I guess, a good way to do it. You can take two strategies, and you can look at a Sharpe ratio, and you can say, well, this one has to be better because the Sharpe ratio is higher. And again, for those who don't know, the Sharpe ratio is just essentially a risk adjusted return saying, you know, how much how much volatility in your returns is it?

Michael: 15:12

Now, the problem is every single one of these ratios will tell you something and then not tell you something else. So the the reason I have such disdain for the Sharpe ratio is it punishes all volatility in returns, upside and downside. So if you have a strategy that say normally does okay, and every now and then you just knock one out of the park. Right? You're you're churning along, you're making money, and then, oh, man, you you got lucky and you made a whole bunch of money.

Michael: 15:39

The Sharpe ratio will actually punish that versus a strategy that consistently makes money without any sort of upside or downside volatility. So looking at, and if you're going to use any of these ratios or any of these things to optimize on, I think it's super important that you familiarize yourself with the mathematics behind it because of things like that. I've seen people say, oh, you know, I'm gonna pick this one strategy simply because it has a higher Sharpe ratio. And then like you mentioned, you look at the equity curve and they're making money slowly over time. And then in that other one, it's like every now and then there's a huge spike, and that ratio is punishing you.

Michael: 16:18

And I I don't know about you, but I would I would like a strategy that makes money most time and every now and then makes a whole bunch of money, whereas the Sharpe ratio would not.

Dave: 16:28

So you like the spikes up too. Yeah.

Michael: 16:30

Yeah. It's like, you know That's...

Dave: 16:32

I think it seems like something that's good. Yeah.

Michael: 16:36

It's like... You know? And then to counter that, there's a rate ratio called the Sortino ratio that only punishes downside volatility, but that has all of its own flaws and its own way of of kind of messing with the data. So, you know, I always think of these when, you know, I was in business school, they'd always talk with these accounting ratios, like the quick ratio and the cash to debt ratio and all of these. And they were always very honest that none of these tell a story by themselves.

Michael: 17:06

They all have to get compared to other things. Know, some companies are gonna have, you know, software companies are gonna have very low overhead. So they're gonna have really high earnings per per whatever they're spending on costs. And, you know, a company that makes trains is gonna be completely different. But, you know, not understanding the differences in these ratios, it just just becomes very lazy, I think, for a lot of people who just look at at these ratios and think they're gonna tell them enough about how it's going to feel to trade a strategy.

Michael: 17:39

And then all of a sudden, they get in the real world, and they realize these ratios don't really mean anything.

Dave: 17:43

Yeah. Yeah. I think... I'm a little embarrassed to say that, you know, every time somebody mentions Sharpe ratio, I have to go look it up. I mean, I kinda know the concept, but it is, like, a commonly used one that I never even look at.

Michael: 17:58

So And not only... You know, if it was just amateurs doing it, that'd be one thing. But this is what's taught in, the CFA and the CMT. And and if you are somebody out there who is trying to raise money, like, with a hedge fund or or some, they will look at a chart ratio, which again is just volatility of returns. Think about, like, a Bollinger Band on the chart.

Michael: 18:22

They're looking for, like, the tightest, you know, move on on a individual chart.

Dave: 18:27

And So isn't there... An important component of Sharpe is also the risk free adjusted, the risk free rate of return. Right?

Michael: 18:38

And that's That's part of the conversation.

Dave: 18:39

Time a little bit. And Yeah. So it's kind of an... It's it's... I mean, I could kinda see the appeal.

Dave: 18:44

It's a little bit enticing to use that. Well, it's

Michael: 18:48

it's essentially saying... And and we talk about this all the time. If a guy comes up to you and says, oh, I just made a $100,000 on a trade. To us, it's a meaningless number. It's like, oh, great.

Michael: 18:58

Did you risk 10,000,000? You know, is is it, is it something that is kind of repeatable in nature? So it's a very simple, a way to say, okay. This is... I have I have a sharp ratio of two.

Michael: 19:13

So that means that my returns are very smooth and very consistent. The problem is it doesn't incorporate things as much like time, and like we mentioned, it punishes upside volatility. But the reason it got so popular is because if you are trying to raise money as a fund, that is kind of the best thing that you can tell people is consistency of returns over over absolute returns. And all of this kind of sprung up a lot after 2008 where people were making whole bunches of money, but taking on way more risk than they thought and just benefiting from, you know, really, really smooth bull market. So it was an attempt to say, yes, you're making a lot of money right now, but you're taking on a lot of risk to make a lot of money.

Michael: 19:59

So, therefore, that's less desirable to old people who are investing in hedge funds than people who are taking on a little bit of risk to make, to make more money.

Dave: 20:08

Yeah. So when you step back, you could kinda see the value of a standardized metric that people are comparing. Right? But the way I look at it is I don't wanna be comparing myself to other people. I I only want to...

Dave: 20:27

Like, I... That, I think, would cloud the way I think. Like, I wanna see... I just wanna look at my strategies. I wanna see how well I'm doing and how well I...

Dave: 20:37

What I can do to improve them. So... And I don't really see a ton of value in, like, standardizing across the industry. So you can see, okay, this Sharpe ratio is better than that.

Michael: 20:51

Yeah. And, again, it always becomes a problem, then they invent a new ratio, like the Sartino. And then that creates its old kind of problems. And I think what it comes down to is that if you are looking at these ratios to do it, you have to include a lot of them and and do some sort of kind of cross sectional checking like that. Like, you know, I see people who optimize for drawdown.

Michael: 21:17

Right? They just want to experience a lower drawdown. Right? Some people optimize for just absolute return. You know, I want to just make the most amount of money.

Michael: 21:27

But you can see how I think much simpler than even the Sharpe ratio, you can see how those ratios could be super problematic. Because if you're optimizing for just making the most amount of money possible, well, you know, that the sequence of making that money could be could be hard. It could not... You know, we're we're making fun of the strategy of the the one that just goes up slowly over time and then every now and then has an upward spike. But what about a strategy that loses money most of the time and then every now and then has an upward spike.

Michael: 21:57

You know, that could be the best mathematical thing to make the most amount of money. But then the question is, could you stick with it? You know, for how long are you gonna be in drawdown? What's that gonna do to you kind of mentally? So then, you know, most people will do a some sort of combination, comparing metrics in some way.

Michael: 22:17

You see this all the time of, like CAGR versus max drawdown. How much money do I make on average? And then what was the worst pain that I needed to experience in order to make that money?

Dave: 22:29

Yeah. I think that's a really good metric to use. Yeah. I don't I look at several metrics when I'm evaluating trading strategies. They're all super easy.

Dave: 22:46

They're all very easy to to compute. They're very easy to understand. And I don't look at just a single one. I'm looking at several. So before we get into that, do you have any other...

Dave: 22:59

Alright. So you you got Sharp. You got Sortino. Are there any other ones that you think, okay, this is... This one's really bad or, like, particularly too popular, overrated?

Michael: 23:10

No. There's, like, the ulcer index, which is is kinda weird as well. But, no, I I think they... Those are the two, like, really egregious ones. And then the rest of them are just all bad on their own.

Michael: 23:23

And I I think that's gonna be one of the main takeaways is that every single one of those is horrible completely on its own. And I I think, you know, either looking at KEGAR or looking at max drawdown on its own will will kind of paint the easiest example for most people. Imagine if you just looked at max drawdown on its own and it was really low. Well, that tells you absolutely nothing about how much money you could potentially make or or or what the the, you know, distribution of returns would look like and and things like that. And so I think that's the main takeaway is that all of these ratios suck.

Michael: 23:59

Like, every every single one of them is bad. The question is how can we kind of combine them and create something to optimize for, in order to mitigate the worst parts of each one of them in in in some sort of way that will end up making sense.

Dave: 24:15

Yeah. So I think you're right. I mean, you're definitely right when you said a few minutes ago that, you know, the path to get to the profit is the important thing because that's where you're gonna feel the pain. Like, how much pain do you have to endure to get this profit? And...

Dave: 24:38

Yeah. So that's a really important way to look at it. And that's why the equity curve, just looking at the picture that the equity curve shows, is so valuable because you can see right on there exactly the drawdowns. Can... And and you can imagine yourself in that situation.

Dave: 24:57

Okay. What's this gonna feel like? You know, there's a drawdown for fifty days, and it's this deep. How how am I gonna feel when I'm trading the strategy? You're not gonna feel really good.

Dave: 25:09

So that's really the main thing I'm looking at when I'm evaluate... Evaluating strategies. The... And the the... Actually, the the downside and the upside of that metric is you can't...

Dave: 25:25

It's not a metric. It's... You can't instill that into a single number by design. So that's a downside, but also an upside in that you can't do that.

Michael: 25:36

But why not, I guess, is the the kind of question I'm asking. Why can't, you know, I... A linear regression of... Like, are we just... Are we in?

Michael: 25:49

I guess the the problem is, you know, if we start to do that, are we ain't gonna end up just getting to the same point that, you know, we just complained about two seconds ago where we create our own our own metric that incorporates a whole bunch of benefits and then a whole bunch of flaws in those benefits as well. But this is something that I've I've thought a lot about and I'll probably continue to think about because I I totally agree with you and I just don't want it to say, okay, we agree you know, end the episode because I think there's some improvement to be made here where, yeah, I I wanna look at the equity curve, and I wanna know, you know, one of the things I always look at is just percentage of profitable months, you know, and you can see that in those are gonna kinda line up if you have percentage of profitable months and an equity curve, they're gonna kinda line up together in in a lot of cases. But I'm always trying to figure out how could I I optimize that process either with AI and and, you know, just machine learning kinda like vision...

Michael: 26:49

Even just having it take screenshots of the equity curve or whatever it is. But why hasn't anyone figured out a way to to optimize that? Because we are all looking for the same thing, and that is a a smoothness of returns that allows us to size up in a position that allows us to be more confident in the returns of of that position. Like, why isn't there... Like, why can't we just math it?

Michael: 27:13

And that always Yeah. Always... Sorry. Just like you were talking about in your in your intro there, just feels like there's a way to automate everything, and we just gotta think hard enough about a way to do it and make our life better.

Dave: 27:27

Yeah. I I think with this in particular, I I think you... What... Actually, what you said is, like, we're all thinking about this in the same way. I think that's not true.

Dave: 27:36

Like, everybody has different risk profiles, different preferences, different life circumstances, different incomes. So it's just really hard to distill it down. I think that's why you have so many metrics and people using different ones. So I don't think it's just smoothness of the curve because, yeah, you you could do that. You're like, there is a metric for that.

Dave: 28:03

I mean, it's... You can see that in the cruncher. There's a metric for exactly for that. And you can you can look at that. But smoothness of the curve says nothing about total profit.

Dave: 28:15

Like, you could have a smooth curve that... Where each trade isn't so profitable.

Michael: 28:21

Mhmm.

Dave: 28:21

Right? So there's all different sorts of factors, and that's why I think you should look at multiple.

Michael: 28:28

Yeah.

Dave: 28:28

So as you were mentioning, I think you mentioned the ulcer thing, which reminded me of the place I learned about all these. In in Amibroker's backtest report, it puts a whole bunch of Mhmm. Metrics in there. Some that I have glanced at and didn't even bother, but there's a whole bunch in there that you can look at and get curious about and see what's out there. And some, you you know, you might be drawn to and and love it.

Michael: 28:59

Well, that's, you're right. You know? And even when it comes to the equity curve because the best looking equity curve in the world would be like a T bill. Right? They would...

Michael: 29:08

Because you just print money every single month. It's just not a lot of it. So it's good even with the equity curve, you have to combine that with some data. So, you know, we've done a lot of, I guess, crapping on, some of the ones out there. But let's start talking about some of the ones that you might wanna add when you're looking at the equity curve because, you know, we both agree the equity curve is is gonna be king.

Michael: 29:31

It's gonna give you the best feeling of how it is to trade it. But individually, and and one when you were talking there that really stood out that I do spend a lot of time looking at is just expectancy, which is the idea of how much on average do you make per trade. And I I like expectancy because, like we mentioned, a really smooth equity curve, but a very low expectancy per trade to me makes me worried about, you know, things like slippage or or weird things really destroying an edge. Because if I'm trading very frequently and say I've got, like, you know, a point 1% expectancy on on every single trade, that is really easy to eat up. But if I've got like a 5% expectancy on every single trade, I know that it's just much more of a forgiving strategy.

Michael: 30:27

I can miss fills a little bit more, like slippage could be more of a factor. Things could just go wrong. And on average, I just find that a little bit of a more robust number to look at. Is that something that you focus with expectancy?

Dave: 30:43

Yeah. So I think we should clarify with expectancy because when you say expectancy, I think of a certain definition of it, which I think may not be standard.

Michael: 30:55

Okay.

Dave: 30:55

So the way I think about expectancy is average r multiple. So

Michael: 31:02

Yeah.

Dave: 31:03

And don't think it's a risk based metric. So, basically, you you calculate one r as the distance to your stop.

Michael: 31:13

Mhmm.

Dave: 31:13

And it's average risk units or, you know, units of r. So if you have... If you're risking a $100 by... And by that means, you know, distance to the stop, not how much money is at work. Mhmm.

Dave: 31:28

That's such an important concept. I mean, everybody... If you... Every listener now, if you don't understand that concept, the difference between how much you're risking versus how much money you have at work in a particular trade, so important and critical that you understand that that difference. I mean, that was...

Dave: 31:48

I was a completely different trader once I understood that. That was just fundamental.

Michael: 31:54

R multiple and... What's it? Van Tharpe. He's got a lot of... He was, like, kind of the godfather of that, but, yes, thinking of R multiples.

Michael: 32:01

And that is one way to look at it, and I do look at that as well. But I'm specifically talking about either percentage, usually percentage, average percentage amount per trade. Yeah. You know? And for both of those things, I I agree, makes sense to look at.

Michael: 32:19

But the reason I really like that expectancy number is what I was talking about, which is the fragility of the system. I know how... I... I've had people send me systems, say, hey. Can you take a look at this?

Michael: 32:29

And the equity curve looks good and, you know, all these ratios are are looking amazing. But, you know, they're making, you know, point 1% on average per trade. And I look at that and I say, you know, you add a slight amount of slippage or delay or or something, and the whole system falls apart. When that expectancy number gets way higher, it's it's less about, you know, this is a a better system to trade, but I just look at it more as this is a less... At least fragile system, to to shift from a, hypothetical backtest world into the real world.

Michael: 33:03

Yeah. You know, any degradation that would have happened is just gonna be a little bit a little bit different there.

Dave: 33:09

Yeah. You want some room so you don't have to have perfect execution to still make money with the strategy. Right? There's some strategies where our backtests where you're like, okay. Yeah.

Dave: 33:19

Your execution's gonna have to be actually absolutely perfect to to make money with it. So so, yeah, I think it's... I I think expectancy and what you talk about average portrayed is a is a really important thing. I... For many years, the...

Dave: 33:38

Mainly, the only thing I would look at is... Or I would look really hard at expectancy. That was the most important thing that I would look at in in optimizing strategies. And the problem with that is when you get really small distances to the stop, that's rewarded, right, with expectancy. So that's the danger in optimizing solely on that without some floor for that distance or really understanding that.

Dave: 34:11

Because what you see is you have these huge outliers that could have... Make a dramatic have a dramatic effect on your strategy if you're not careful. So that's an important thing to to consider.

Michael: 34:24

And it just it just keeps coming, I think, back to the main takeaway, which is every metric, if you think about it long enough, you... You'll find a flaw, a correct flaw in in every single one of the metrics. But it doesn't mean they're useless. Right? It doesn't mean Yeah.

Michael: 34:38

Except Sharpe ratio. I I just... I really just... I've gotta... Yeah.

Michael: 34:42

The the fact that I I still in my brain know how to calculate it, really really bothers me. It's just like that's moments of my life from university that I'll I'll never get back, that I had to study. But it's it just... It it goes to show you that it has to be some sort of combination of these, and that's why, you know, we we are systematic traders. And a lot of people think systematic traders means absolutely no discretion, absolutely no emotion, and, you know, we are just robots.

Michael: 35:13

When it comes to the trading, yes, I don't hit the buttons to buy or sell. Right? They will just happen. I I don't need to be there. But you can see how we've listed, like five to 10 different ratios and have found a a use for a lot of them and a misuse for a lot of them and shows that it's going to be the discretion is going to lay in which of these values are more important to you.

Michael: 35:40

Right? You know, expectancy for like fragility, but like you mentioned at the same time, you gotta make sure that that's not coming from, you know, a a place of just a really tight stop loss. And then also a CAGR to make sure you're making enough to make any of this worth your while, but also making sure that CAGR is not, being achieved through just wild risk taking. Right? You know, smoothness of equity curve, but not a T Bill one that, you know, you're you're still...

Michael: 36:11

The equity curve is smooth, but the the area is there. So then you have to look at them. So I guess one thing to think about is, a, you gotta find out... I think this has to be one of those things that it's starting at your goals and working backwards. You know, if your goal is...

Michael: 36:27

If you just wanna sit down, you just wanna say, I just want consistency of return. That's all I care about. Maybe you're trading for a living, and this is your primary income source, or, you know, you're older and retired or whatever it ends up being, then it's okay, that is my end goal. Now let me work backwards and pick, I don't know, feedback on this, but like three to five things that both express that goal, but also check on each other in a way, and then start optimizing for for that particular value. Because that person isn't going to optimize on total return, which is what I always optimized on when I was 20 with no kids, and now that I'm old and and have two of them, it's that goal that starts it, and then everything for for optimization works backwards from that that particular goal.

Dave: 37:18

Yeah. I think that's a good way to put it and a good way to think about it. And I have four or five metrics that I do look at, and I never thought about them sort of checking each other exactly. But that is that is essentially what they're doing. I I think that's a really good way to put it.

Dave: 37:36

So I do look at

Michael: 37:37

through those?

Dave: 37:38

Total profit. Yeah. I I do look at total profit. Of course, it'd be silly to... Like like we've said, it'd be silly to look at one, and that would be silly to look at just total profit.

Dave: 37:49

I look at win rate. Now we all know or we we both believe, I believe, that win rate's overrated. And so so I think... So so why do I include it in there? Well, I know just from experience that...

Dave: 38:09

So there was a there was a system I traded early on. Had a great expectancy. Had an expectancy of of about one, which is like everything at risk, it was gonna make one. But the win rate was like 20%, 25%, and it didn't trade a bunch. That was ultimately the problem with it.

Dave: 38:32

But I just know that if it's below, say, 30%, 35%, it's just psychologically difficult to trade because you're gonna have streaks where you're gonna have many losing trades in a row, which is just psychologically difficult. Yeah. And Forget even the drawdown that comes with it. Just like, okay. I'm doing this every day.

Dave: 38:55

I've got... I remember one time I had 14 losing trades in a row with this one system.

Michael: 39:00

And that's what I was gonna say is that a 20% win rate, you could expect 20 plus trades in a row regularly, you know, if you traded it for long enough just through the numbers. So, yeah, it becomes... It's one of those things. Yes. We'd all like to say win rate is completely useless.

Michael: 39:15

And and like I've explained a few times, I always... My brain instantly goes to the extremes to see if if the rule is valid. And I'm like, would you trade something of a 1%? Yeah. It's like if I said, hey, this strategy is gonna make you a ton of money over the long run, but as a 1% win rate, that's really hard.

Michael: 39:37

Like, yes, you could probably do it, but you just wouldn't want it to be your only system. So it doesn't mean throw at the system entirely, but it means maybe when you're looking to optimize, can you up that? And then I think when you have a system like that that's at its extreme, so like a 20% win rate, it's gonna be a lot easier through thinking of the correct optimization to go from 20% to 30% than a strategy that's like 60% to make it 70%. You know, even though that's a 10% jump, there's probably some low hanging fruit in that particular setup that might be easier to find to say, okay, if I just cut out these number of trades, I can eke that up to like 25% or 30%. So yeah, it's, you know, the the example I always give with like win rate is, you know, if you're looking to lose weight, I could tell you the most optimal thing to eat, but it wouldn't matter.

Michael: 40:32

You know, if I just say, listen, you have to have chicken broccoli and brown rice five times a day with no seasoning and nothing. It's like, yeah, it's it's optimal just like a low win rate strategy might be optimal, but it's not gonna be fun. And if it's if it's bad enough, you're not gonna do it. You're gonna break your rules. You're gonna...

Michael: 40:50

It's gonna force you off that path, so it doesn't matter if it's the optimal.

Dave: 40:54

That's the thing is you don't... These win rates are projections. Like, we're we're predicting the future here, which is hard. Mhmm. So you never really know with a 100% confidence that your win rate is going to continue in the future.

Dave: 41:12

You have to have faith that it is. You do a lot of back testing and research to become more confident. I mean, that's really how you get more confident in a strategy. And the the thing that is difficult for people is they don't have a path to confidence. So so they can never really put a lot of money at risk because they don't have a way to get more confident to to be able to do that.

Dave: 41:41

So... And, you know, that's just way harder with something with a lower run rate. It's... And, you know, the the streak that I mentioned a second ago where I lost 14 trades in a row, that was from a strategy with, I think, a 35% win rate. So it's...

Dave: 42:01

It will happen. This is, you know, this is guaranteed to happen at some point, and you're gonna have to live with it. And you're in in... When you're in that situation, you're gonna doubt. You're gonna have doubts.

Dave: 42:11

You're like, wow. Okay. The back test says this, I've lost 14 in a row. What the heck? I mean, this is this is awful.

Dave: 42:18

I... Know, you're you're gonna lose faith in the system. And when you lose faith, you're gonna size down. And that's the part that that you're gonna quit. You're gonna quit trading the system, and ultimately, you're gonna quit trading when you're in these drawdowns.

Michael: 42:35

Well, and especially if it happens right away. Like, we'd all like to imagine, oh, I... But I've been trading it for two years, and then I get smacked with the win rate. And I go, okay. This this will be fine.

Michael: 42:45

This will come back. But what if it is your first trade is one of 14? And, you know, the first 14 trades you take with the system, which is just as likely as as it happens two years in, is that is that getting hit. And that becomes just so hard because now you've... Don't even have a cushion, and you don't even really have any sort of time that has gone by to see the confidence of it.

Michael: 43:13

So, yes, it's, you know, it's it's the win rate mathematically is is way overrated. But in a human level, you know, having something that gets up to that fifty fifty or or even above, even if it's not the strategy, maybe having multiple. And this is how personally do. I've got some very high, like, 65, 70% win rate strategies. And then I try to balance those with the 30% win rate strategies to kind of help with the mental balance of, okay, at least this one when it triggers will be, generally speaking, way more.

Michael: 43:50

But yeah, so you've got to look at it even though it mathematically just doesn't really make sense to. You have to know it exists and you have to know what it's gonna feel like to trade.

Dave: 44:00

Yeah. And I think... Well, I think the message for beginning traders though is you're gonna be... Like, people don't like to be wrong. Like, fundamentally, you've grown up in school where you're trying to get hundreds on tests, and a 69 is a failure.

Dave: 44:23

Right?

Michael: 44:24

Mhmm.

Dave: 44:24

It's an f. So you've grown up with this whole mentality, and then... And you're... You still have that. You want to be right about things.

Dave: 44:35

And part of trading is, like, you're gonna be wrong, and you need to be able to handle that. So you're gonna be your tendency is to be to overrate win rate. Like, you're gonna... It's gonna stick out more in your mind. And what I like to tell people is, do you wanna you wanna be right or do you wanna make money?

Dave: 44:57

Those are two different things when it comes to trading.

Michael: 45:00

Yeah. And it's why I think it's important to look at all these other other metrics as well. Right? Because they might help with that, you know, knowing that win rate won't save you, but it might make it it might make it feel better. So you have how much...

Michael: 45:17

You have your expectancy number, you have win rate. I'm sure you must have, like, CAGR in there somewhere.

Dave: 45:24

Yeah. So so there's... The other ones I look at are profit factor.

Michael: 45:32

Yes. We should we should explain that just to people because that's a more obscure one, but I think is is one of the best. And a profit factor is essentially, you sum up all of your winners and you divide them by the sum of all your losers. So if every winning trade was, you made $200 on all of your winning trades throughout the entire backtest, and you lost a $100 on all of your losing trades on all your backtests, your profit factor is two. And the the beauty I like about profit factor is it kind of negates win rate and profitability.

Michael: 46:09

It kind of evens those out. Because you could think about it, you could achieve those numbers in two ways, with a whole bunch of wins and only a few losses or giant wins and tiny losses, and both of them could reach the same thing. So it's kind of agnostic to the the win rate versus the kind of profit per trade has its own flaws, like everything, because it doesn't tell you how you got there. But I'll... I do use that one as well.

Michael: 46:35

I think that one's very underrated and and

Dave: 46:38

very The reason I started using that one is I started trading some strategies that didn't have a stop. So that forced me to use something besides the expectancy value because, okay, if you don't have a stop, then... I mean, and and all sorts of caveats here, I wouldn't recommend doing that. That's why I think, you know, expectancy is a really good one to start with because Mhmm. You you need to stop.

Dave: 47:09

But it allowed me to use... To to evaluate these strategies without having to have a stop in there to to be able to commute a metric. So that's the main reason I started using that. And and I like it. I like I like profit factor a lot.

Michael: 47:24

Yeah. And I I... For me, I just like it because it is it is neutral to, like, we... What we talked about with win rate versus... You know, you could have...

Michael: 47:33

Because some of these strategies I run, I have a minimum profit factor that I generally want to achieve or I want to see in in most strategies, regardless of whether it's a 30% win rate or a 60% win rate. And then I also find sometimes it can be of, like, a bullshit detector. If I ever test something and it's got a profit factor of, like, 10, I'm like, okay. Broke something. Right?

Michael: 47:55

It's just... You... There's there's a certain levels that you get to where it gets so high that you're like, there's just absolutely no way that this is likely possible. And if I did, I'm retiring soon. But it's...

Michael: 48:08

Yeah. I I just like it because it's a it's a good summation of a bunch of other ones together. But just like we talked about, then you have to dive into that number to see, you know, what side of it ended up making you the the money there.

Dave: 48:21

Yeah. So the other one I look at is... I'll I'll look at this very closely with everything I do is trades per day.

Michael: 48:32

Mhmm.

Dave: 48:33

Which, of course, you're not gonna be... Wouldn't make sense to look at that one alone. But what I'm looking for is I wanna have more trades in the system. More trades, the better.

Michael: 48:42

Mhmm.

Dave: 48:43

So I'm looking at trades per day, I know that if it's below... If it's significantly below one, I... It's just gonna not... I I just value it less because I know I'm not gonna be looking at those... At at the the trades that come through very frequently.

Dave: 49:03

It just is gonna feel... It's gonna get lost in the other strategies that do have more more than one trade a day.

Michael: 49:12

Well, and also, it's going to be harder to optimize down if it experiences difficulty. Right? If you Yeah. If you're doing 10 trades a day, you're going to get more real time data to figure out what is what you can kind of key in. For me, from the swing trading side of things, I value the same thing.

Michael: 49:32

Have a lot of trades. For me, a lot of it is optimizing to for number of days held. You know, I like three to five days, you know, two to three even better. And I have some strategies that... You plug yours...

Michael: 49:46

That I that I hold for, like, a month, like a whole month. That's crazy. I know. But, I I I prefer the shorter term ones just because I know there is that certain amount. There's more kind of meat on the bone for optimization that if it starts to go into, an...

Michael: 50:03

A prolonged drawdown or a drawdown bigger in the back test, there's more to look at than the... These other ones that may have less frequency of trades, but I essentially use them just to be efficient with with buying power and being able to hold things for some time if the edge is large enough.

Dave: 50:22

Yeah. So, actually, the the way... It's probably worth pointing out the way I compute that. So it's... It seems like it'd be super easy, but what I like to do is get...

Dave: 50:39

Weed out the weekend days. And so, basically, what you do is, like, figure out the first date for the first trade in your back test, figure out the most recent date for the most recent trade in your back test, figure out the number of days in between those. Now that's gonna include weekends. Like, the easiest way to compute that is just to do raw number of days. But...

Dave: 51:05

So what I do is, like, figure out the the number of years between those. Like, reduce it to years. So I've got, like, one point, you know, however many. You've got a number of years down to two decimal places. And then compute that so that knowing that there's, like, two hundred and twenty trading days in a year, something around there.

Dave: 51:24

I think that's what I use. And then that reduces

Michael: 51:27

Two fifty two, I think.

Dave: 51:29

Yeah. So it reduces it to number of trades per trading day. That's the easiest way to make that computation.

Michael: 51:37

Yeah. And, you know, that's the that's the nerdy extra step. But I I think for most people, you'd probably find with just the the number of days out there. Assuming you're comparing apples to apples, I think that'd be the important thing with that one. If you're gonna do that calculation for one, just make sure you do it for all of them.

Michael: 51:55

Or else one may seem like it trades more frequently than the other because you end up don't, you know, not doing that. But yeah, having that as a metric. Is that all of them or do you have... I've got

Dave: 52:08

one more, but I've got, again, we're coming up on time here, I've got, like, a ton more that I wanna talk about. So

Michael: 52:18

Well, maybe we continue this next week or

Dave: 52:20

I think we need to.

Michael: 52:22

Or down the other one. And I... Again, it's the the main takeaway, and and I'm sure we'll we'll reiterate in the next one as well, is just that, you may look at some of these and they might not matter to you, and that's fine. And that's... It is a bit personal, but the interplay between these metrics, I think, is is absolutely everything.

Michael: 52:44

Right? Any of these in a vacuum don't tell you anything. You need to do some, which is why still this is where the discretion comes in. You know, running a strategy and looking at it and, you know, if you are... And let's just say this is for, I guess, a little bit more advanced because if you are someone who is a losing trader, any amount of of win is going to be good.

Michael: 53:13

You know, you you should start there. I don't think you should get too insanely into the weeds, but this has a lot to do with either refinement of strategy or comparing strategies amongst themselves. Right? So, you know, don't... I'm just thinking of the guy who's just getting started with his first strategy.

Michael: 53:31

I would kind of push that person just to go for it and and get into it and then worry about all of these details later. But they do become hugely important when you've got a limited amount of buying power and a limited amount of things that you can do, and you're trying to figure out what is the best. Well, best is going to be some combination of these ratios that make the most sense to you and not the guy sitting next to

Dave: 53:55

you. Yeah. Yeah. So why don't next time we talk about... We'll continue this conversation.

Dave: 54:05

We'll have... Because since the last time we talked about this, I have made some changes in the way I do things. I've added this one metric that we'll talk about next time. But also, I've got a plan for two or three others that I'm I'm gonna do some exploring on. And I I I think, like, I think we'll be really good, and I think it'll be a good discussion about how how, you know, more advanced traders start thinking about this.

Michael: 54:37

I think that's, like, the the hardest tease we've ever done for a future episode. So we should probably should probably leave that at that and make sure you guys are, you know, following along wherever you're you're seeing this or hearing this and and tuning in. But as always, I'm Michael Nauss.

Dave: 54:53

And I'm Dave Mabe. Talk to you next week on Line Your Own Pockets.