The Strategic Trader
Detailed Strategy Evaluation

Testing setup: Risk/Reward

I believe any tradeable edge should find trades that quickly become profitable. However, there are many ways to make money. We should also evaluate a strategy based on its risk/reward profile. A strategy may not be profitable 3 or 5 bars into the future like we have been testing, but may still signify a turning point with low risk. Before evaluating strategies based on risk/reward we have to establish a baseline to eliminate bias in our data set.

In this article, we will once again be running random simulations. We will use a 1:2 risk:reward ratio. Entries will be random based on the target number of trades (500,1500,5000). The strategy will set a profit target 3 *ATR(14) above the closing price and a stop loss 1.5 * ATR(14) below the closing price. The strategy will exit when the first target is hit or end of the day. Whichever comes first. After 100 random simulations we will then average all of the results and produce targets like we did in this article: Testing Setup

Baseline Results for 5,000 trades (Long):

Percent Profitable: 34.18%
Expected Return:  -$29,377
Target Percent: 36.86%
Target Return: +$38,493

Baseline Results for 1,500 trades (Long):

Percent Profitable: 34.37%
Expected Return:  -$8,587
Target Percent: 40.79%
Target Return: +$36,331

Baseline Results for 500 trades (Long):

Percent Profitable: 34.73%
Expected Return:  -$1,886
Target Percent: 45.54%
Target Return: +$26,455

Now we will perform the same simulations to determine the bias for short trades. We are still using a 1:2 risk/reward ratio.

Baseline Results for 5,000 trades (Short):

Percent Profitable: 32.23%
Expected Return:  -$34,763
Target Percent: 34.8%
Target Return: +$33,439

Baseline Results for 1,500 trades (Short):

Percent Profitable: 31.98%
Expected Return:  -$11,147
Target Percent: 37.69%
Target Return: +$32,599

Baseline Results for 500 trades (Short):

Percent Profitable: 31.58%
Expected Return:  -$4,478
Target Percent: 40.94%
Target Return: +$21,362

Based on these results it is very clear that using a 1:2 risk/reward ratio requires a great entry. I believe the random entries fared so poorly due to all of the noise in the markets. This should serve as a good indicator when comparing edges.

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