When you trade the markets, you really don’t know the exact probability of winning or losing on a given trade. Additionally you won’t know exactly how much you will profit or lose. What a CTA does is extensive historical testing on his / her concepts, and trading strategies to get an idea of what to expect. They will also pull huge data samples of market prices from either a data vendor or from real-time trades, in order to get a clearer picture, and to really try and nail down the “expectancy” of their particular methodology and trading system. After investigating trade-by-trade and crystalizing the risk to reward ratio of each trade and its frequency of occurrence they have a far greater understanding of their trading system and what is to be expected with any given trade. This takes work and can be expensive but is critical to success and confidence in your trading methodology.
If a CTA is purely a discretionary or nonsystematic trader they will review their past trading results and delve into how they are making or losing money. They will look at each individual trade on a one-lot basis, then with the knowledge of what their risk was going into the trade (initial exit point) and the closed profit or loss, they can exactly calculate their risk-to-reward ratio for each individual trade, and also get some confidence and certainty on the risk-to-reward on future trades.
Commodity Trading Advisors often refer to a trade’s reward-to risk ratio as an “R Multiple – R is simply a symbol for the “initial risk” on a given trade. To calculate this ratio (R multiple), take the amount of profit captured after exiting a trade and then divide this by the initial risk you assumed at the outset (keep in mind most top CTA’s know where they are getting out of a trade, especially a losing trade, before they ever get in). For example, if you entered a trade with an initial risk of $700 and made $2100, the R multiple would be 3. R multiples can also be negative (-3) if you have a losing strategy or trading system.
CTA’s track every R multiple for every trade they initiate so obviously they know the general reward-to-risk they are taking on in any given trade, but also with the back-testing they have already analyzed hundreds if not thousands of trades that make up their systems. These results will then make up an historical simulation which is the inputs and components of “Expectation”. The pattern and consistency of these R multiples will be the determining factor of a CTA’s method or trading systems overall expectancy. Armed with this knowledge a professional CTA can then define appropriate position sizing given their AUM (assets under management) and apply that to their trading methodology in order to meet their overall objectives.
There is obviously much more to this topic which I will follow-up with tomorrow but wanted to lay some initial groundwork for you before we move forward.