How to Increase Your System's Edge

One method of trading that a lot of our forex traders' use, is holding their position for only a very short amount of time and a very small number of pips. Essentially what they are trying to achieve is a high accuracy edge.

A trading systems' edge is what is going to make it profitable in the long run. A great example of an edge is a blackjack game at a casino. Based on the rules of the game, the house has a very slight edge over the player. After a lot of repetition, a great sample size of hands is played and the casino exploits the edge and makes a lot of money. This should be the same with any system. It is critical to understand that losses will happen and the only way to win is have an edge over the long run.

With this in mind different systems have different types of edges. In this article I will show you a great risk management trick called the Martingale that will help you maximize the returns of a high accuracy system. Before I go on, let me briefly describe what the Martingale Strategy is. Then I’ll show how it can be used. Here’s how it works in theory:

In the Martingale Strategy you increase your position size when you have multiple losing trades in a high accuracy system. When the system’s performance reverts back to the mean and begins to win again, the losses are quickly recouped because of the increased size of the winning trades.

Okay, let’s get started.

First, let’s talk about a few of the key components that a trading system or strategy should have:

Reward/Risk Ratio and Accuracy

The reward/risk ratio (RRR) is the expected profit divided by the expected loss on a particular trade. How much you are risking and how much you expect to make. Accuracy is simply the percentage of trades that you are correct on.

Your reward/risk ratio for a particular system has to be consistent with the accuracy (winning percentage) of a particular system. I will go into a couple of examples below, but the bottom line is that the RRR and the Accuracy are usually inversely correlated. In other words, the higher the RRR, the lower the accuracy is, and vice versa.

Example:

If you are using a system that is only holding for a few pips and you are trying to achieve high accuracy, you don’t need a high RRR at all to have positive expectancy. For example, if your winning percentage is 90%, you can afford to have an RRR of .5.

Using a simple example of 10 trades:



When adding advanced risk management concepts like dollar cost averaging and pyramiding and a Martingale principle, you can enhance your expectancy further to create some really nice results.

In this article, I will explain how to maximize the returns on a high accuracy system by using the Martingale principle. We at forexyourself.com have numerous proprietary trading accounts and are currently working on a high accuracy system for forex that takes advantage of this very principle, and the system is showing very promising results.

Before I talk any further about this principle I need to set one golden rule in place. This is what is called the 2% Rule. According to this rule, a trader cannot risk more than a certain percentage of his account on any single trade. In my opinion, this is actually the holly grail to trading any instrument. Since I am very conservative, for me the number is 2%; some traders like to go as high as 5%. I would strongly recommend not risking more than 5%, especially on a highly leveraged vehicle such as forex.

Essentially you have to determine position size based on this rule. The calculation is very simple and we actually have a calculator on our website http://www.forexyourself.com/risk-calculator.php.

Example:

Total account size: $100,000
Maximum single trade loss %: 2% {set}
Maximum single trade dollar loss: $2,000

Now you have to calculate your loss on a single contract based on the distance from your entry to your stop and than divide it into your maximum single trade dollar loss to obtain your maximum position size in contracts or shares.

Entry: 1.1850
Stop: 1.1830
Max $ loss per contract: 20 pips = $200
Maximum single trade dollar loss from above: $2000 (2% of $100k)
Optimal position size: $2000/$200 = 10 contracts

Now that you know how to determine the upper limit to your position size, we can discuss the Martingale strategy.

A high accuracy system will be correct 8-9 times out of 10. The only drawback to this is that your losses will be larger than your winners, as we discussed above. So once you hit a loss, it will take a big bite out of your winners. What if there was a way to recoup that loss very quickly? The Martingale strategy can help you do just that.

First you must understand that it is not a good idea to trade near the upper limit determined by the 2% rule when using a Martingale strategy. So if the largest position you can take is 10 standard lots, when using a Martingale strategy I would recommend you start with 2-3 mini lots.

Since it is statistically fairly unlikely that you will have a great deal of losing trades in a row in a 90% accurate system, you can play with the position size to put the odds in your favor.

Let’s say that you have an RRR of .5; you will loose $2 for every $1 that you win.

As you accumulate your winning trades, keep the same position size (let’s say 2 mini lots). Once you hit your first loss, you can double the position on the very next trade because since the system has high accuracy, the chances of 2 losses in a row are not very high. If the next trade does turn out to be a loser, you double the position again. You can double up to your maximum position size calculated by the 2% rule. Once you hit that size you should just keep that size as you trade until you hit your next winner. However, because you are starting out with such a small portion of your account, this is not likely to happen.

Let me give you an example with the figures that we used above. Suppose you have a system that is 80% accurate and has a RRR of .5, so you make $1 on your winning trades and lose $2 on your losing trades. Let’s say your 1st and 7th trades were losers. You are getting 10 pips on your wins and losing 20 pips on your losses. Let’s run through the example on a 10 trade sample size:

Martingale +60 Pips



No Martingale +40 pips



You can see how the martingale enhances the system.

Now let’s look at an example with 2 loosing trades in a row and see if the martingale helps.

Martingale +50 Pips



No Martingale +40 pips



So keeping the same accuracy, the Martingale system even works with 2 losing trades in a row in a 10-trade sample size.

When using the Martingale strategy, I recommend keeping a few things in mind:

1. Trade very small -- positions can run up a lot by doubling them so start out very small so that you don’t get into trouble.

2. Never Exceed the 2% Rule -- Never exceed your maximum single trade size no matter what.

3. Use this only on a high-probability system.

4. Use back testing to determine your accuracy from a large enough sample size.

Using the Martingale approach can be very beneficial in increasing performance of high probability strategies. I will discuss a few of the high probability strategies in our seminars and further articles. This strategy must be used in conjunction with the 2% Rule and may be use in conjunction with other risk management principles.

Alexander Nekritin is a professional trader with over 8 years of experience. His specialties include risk management and system development. Alexander is the CEO of www.forexyourself.com, which is a forex introducing broker and education company that helps suite client’s needs in forex trading. Alexander has a degree with a concentration in Investment Banking and derivative instruments from Babson College in Massachusetts. You can contact Alexander with further questions at alexn@forexyourself.com. Alexander conducts free seminars on Wednesdays at 9pm EST on risk management, strategy and trader’s psychology to register you can click this link: http://www.forexyourself.com/seminar.