Sunday, 25 March 2018

Accuracy

Lot of traders often inquire for accuracy of my stock future trades.  They normally believe that if accuracy of the trades is high, then there is a high likelihood of making profits.  Else with low accuracy they will never make money from trading.  In short, they see their chance of making money with only highly accurate trading system with the accuracy of 70% or 90% or even greater than that. If you also believe in high accuracy means higher profits, this post will be an eye opener for you.

Lets first try to understand what the accuracy is.  Accuracy is nothing but a measurement of profit making trades out of total number of trades.  As an example, if 6 trades make profit and 4 trades make loss out of total 10 trades, the accuracy would be 60% for these 10 trades.  Now as a trader we cannot use this accuracy figure in isolation as a measurement for overall profitability from trading.  We also need to take into consideration risk reward ratio along with the accuracy.  Combining them both, risk reward plus accuracy, will give us a clear picture of overall profitability of trading system.

Lets try to understand this further with this example.  For 10 trades, if the trading system makes profit of Rs. 1000 each in 8 trades and loss of Rs. 5000 per trade in remaining 2 trades, the accuracy of this trading system will be 80% because 8 trades out of 10 trades make money here.  However, due to poor risk reward ratio of 5:1 (it loses 5 times more whenever it makes loss), at the end of 10 trades, this 80% accurate system will give us loss of Rs. 2000.  +1000*8 = +8000 profit.  -5000*2 = -10000 loss.  So the end result in 10 trades is 8000-10000 = -2000.

Now lets just flip everything here, accuracy as well as risk reward ratio.  A trading system with 20% accuracy and 1:5 risk reward ratio.  8 trades will make a loss of Rs. 1000 each and 2 trades will make profit of Rs. 5000 each.  Hence the overall result with this 20% accurate system will be Rs. 2000 of profit.
-1000*8 = -8000 loss.  5000*2 = +10000 profit.  So the end result is -8000+10000 = +2000.

So with the above example, it is very clear now that to judge the overall profitability from a trading system, we need to look at accuracy as well as risk reward ratio.

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