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Thursday, June 3, 2021

Automated Trading Strategies: Reinvestment Vs Total Investment

We (Automated Trading Strategies) recently received a question from a subscriber regarding total investment. He wanted to know how much a trader had to invest in each strategy (see a description of all strategies here), not just net profit. 

In other words, if we find a strategy that makes $100K a year, how much did it take to make $100K in one year? Did it take $50K or did it take $1 million? Due to the nature of futures trading, the answer can be both. We’re going to take a few minutes to explain why that is in this post.

Reinvestment Vs Total Investment

Any good automated or algorithmic trade is going to move like the market, which tends to ebb and flow. Very rarely is the market direct in its path to a particular point of support or resistance. So it is not unusual, especially for automated trades that use indicators as a trigger to buy and sell, to have high reinvestment.

Some traders view reinvestment cost as the cost of doing business, it’s almost impossible for a day trader not to. You use your account size, which for me is only 2% of $50K on any given day, to make more profitable trades than unprofitable trades. If you make $200, that’s great. $200 is your net profit, between your gross loss and your gross profit, but this doesn’t tell you how many trades it took to get there. It could have taken 11 trades with a gross loss of $1,000 and a gross profit of $1,200. So you lost $200 on 5 trades and made $200 on 6 trades, which put you up $200 on the day. Your gross loss is $1,000 and your gross profit is $1,200 —  net / net you made $200 on the day.

One way that traders measure reinvestment is with the profit factor. Profit factor is the ratio of gross loss and gross profit. Going back to our example, if you’re up $200 after losing $1,000 and making $1,200, the profit factor is 1.2 (1,200 / 1,000). So your breakeven is 1 or $1,000.

Let’s kick it up a notch

What if you made $200,000 for the year off of a gross profit of $2,200,000 and a gross loss of $2,000,000. Net/net, you’re up $200,000 for the year. Does this mean you have to have a $2,000,000 account to trade? Not at all. Gross profit and gross loss are like the notional rather than actual market value of your trades. It’s important, but not nearly as important as the incremental wins/losses.

That’s why we use draw-down as a measure of the % of cumulative profit that has to be used in the reinvestment rather than the % of the account size or gross p/l. So when we say that the draw-down is 20%, using our example, it means we had to give back as much as $40,000 of the $200,000 cumulative profit made over the last year. The higher the draw-down, the higher the capital requirement.

We prefer to measure capital requirement in this way because it takes daily reinvestment into consideration.

So it’s not wrong to focus on net profit rather than gross profit/loss. Indeed, a good automated trade strategy has its eye on both.

The Holy Grail of Trade Strategy

As a quick reminder, our goal is to find the holy grail of automated trade strategy and we think we can find it faster together.

We’ve defined the holy grail of trade strategy to be the following (based on annual performance):

  • Profit factor greater than 3
  • Annual draw-down less than 3%
  • Annual return greater than 500%
  • Minimum daily net profit of -$1,000
  • Avg Daily profit greater than $1,000
  • Less than 5,000 trades annually

We have yet to find this illusive trade strategy, but we’re on the hunt!

If you subscribe to our newsletter, you’ll be among the first to find out when we do.

Subscribe now

Note that we’ve included a requirement for a profit factor of 3.

We believe automated strategies with a profit factor of 3 and higher weed out strategies that aren’t efficient. It’s like an ROA (return on assets) of sorts. Investors like Warren Buffet look for high ROA investments because they make more money per dollar of invested assets. Rather than simply comparing earnings to the number of shares outstanding, or price to earnings, Buffet compares price to the dollar value of assets used to get you to that price. Put another way, instead of looking at earnings potential, Buffet looks at asset potential -- does the price of the investment correlate with the underlying investment in assets. Likewise, we are looking for strategies that create 3x more gross profit than loss.

The end result is an optimization of profitability -- automated strategies that stand the test of time.

The Key To Maximizing Profit Factor

So what is the key to maximizing profit factor?

Answer: Minimizing gross loss.

Based on the work we’ve done so far, the key to minimizing gross loss is to decouple complementary trades. In other words, just because you go long on an upward cross, doesn’t mean you have to go short on a downward cross. You can go long and then exit the long. And/or, you can short and then exit the short. Then you can put a strict conditional around each leg. In other words, you can isolate the profitable trades within the strategy. We found that this greatly increases the profit factor.

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