A subject of conversation in the blogosphere in recent weeks has been the idea that you can have a positive point or pip (I’ll use points for simplicity from now on) balance from your trading, but end up with a negative net P&L. This may sound like an impossibility, but I assure you, it isn’t. Let me provide an example.
Let’s say you do 10 trades. You have a 60% win rate and make 50 points on average for those winners while suffering 30 point losses on the other 40% of trades. That tallies up to a total gain of 120 points (6 x 40 – 4 x 30). This looks like a pretty good result, right?
The problem with the above is that it assumes all of the trades are the same size, the same value per point gained or lost. As soon as you start including trades of different sizes you cause problems with using point accounting to gauge performance. All I have to do is change the size of one of those losers to make something that looks quite positive into something with a negative bottom line.
Let’s say for 90% of your trades each point is worth $10, all of the winners and three of the losers. That translates into a net profit of $1500 (6 x 40 x $10 – 3 x 30 x $10). If, however, you had a really good feeling about the last trade and put on a position ten times the size you normally traded ($100/pt), then the 30 point loss for that final position would wipe out all the net gains from the other 9 trades and end up $1500 down ($1500 – $100 x 30pts). Suddenly the total point gain figure doesn’t seem so good anymore, does it?
You may be thinking you’d never trade 10 times your normal size, but that’s not really the point. You can create any number of scenarios in which the point tally is positive and the actually profits are negative or break-even or decidedly unimpressive because of variation in position size between trades (or just as easily the other way around where it results in much more impressive performance than the point tally suggests). That means unless you always trade the exact same point value, counting points doesn’t tell the real story of your trading.
This is exactly the reason why I’ve been a proponent of using other measure to gauge performance. Obviously, % return is a good one, though that doesn’t factor in risk. Using R is a good way to incorporate risk into comparative performance measurement. Whatever you use, though, just make sure to be aware of both its benefits and short-comings.