Developing a Strategy

Develop an Edge

Following on from the previous post, a little food for thought to help you get started with developing your own advantages.

Over the years, many people have tried to beat the game, some have succeeded, the majority have failed.

Why did they fail?

It could be for any number of reasons; maybe they set their own rules which they subsequently decided not to follow, perhaps the information they used wasn’t reliable, or perhaps they didn’t understand the game they were playing.

As an example, some people walk up to a roulette wheel and think it’s the same as tossing a coin; pick red or black, the equivalent of heads/tails, but they neglect the green zero (the house edge), and/or the double zero (stateside).

Imagine you pick red or black at roulette, there’s 18 red numbers, 18 black numbers, and either 1 or 2 green numbers. We’ll keep it simple for now, and just have 1 green number (zero). So 37 numbers in total on the wheel. The untrained gambler thinks when they pick red or black they have a 50% chance of winning, when, in actual fact, they don’t.

Let’s say they pick red. The pay-out is 1:1 (even money). Their true chance of winning is:

(18 red numbers / 37 total numbers on the wheel) x 100 = 48.65%

The chance of the casino winning is:

(18 black numbers + 1 green number) / 37 total numbers on the wheel) x 100 = 51.35%

The house edge is 51.35% – 48.65% = 2.7% 

You’ve maybe heard the expression “the house always wins”. The reason they always win is because they use a mathematically proven edge against their guests for every game they offer. The 2.7% above is based over the long-term, of course there will be people who go on hot-streaks and walk away, that edge allows for that, for every winner, generally there’s more than one loser. How the house makes money is based over the long term, they know that on average for every 1000 spins of that wheel, their average profit is going to be 2.7%. That’s why their doors are open 24/7 and they keep the drinks coming. They rely on volume. They also impose table limits to help ensure than some big player, in the event of using the martingale strategy after a string of losses on the same colour streak is stopped out by the table limits before the opposite colour lands in.

With the above example, the pay-out is even money i.e. you’re risking 1 chip to win 1, and you have a 48.65% chance of being successful.

Applying the 1:1 pay-out to trading. As an example we place a back bet of £100 at odds 5.0. Below is the ladder showing the potential profit/loss depending on how the odds move.

Scalping

The figures in red do not have commission charged as they are losing trades, however the figures in green would have commission charged, so the actual profit per tick is shown below (in black, assuming 5% commission – the standard commission rate charged by the exchanges when first starting out).

tick movement showing net profit

Let’s assume now that you do 100 trades, you predict 50% correctly, and 50% go against you (assuming you cut them out at 1 tick).

50 trades making a profit of £1.94 each after commission = 50 x £1.94 = £97 profit

50 trades making a loss of £1.96 each = 50 x £1.96 = £98 loss

The commission rate will put you into a net loss (£97 – £98) = £-1.00

This example assumes that the trader is disciplined enough to cut the losses every single time. A lot of people struggle with this, and that’s one of the key reasons why they fail at trading. Market noise will push them out of the market and they cut every loss at 1 tick. The markets tend to ebb and flow up and down the ladder, and they have left themselves very little room to manoeuvre. In fact, they’ve pretty much left themselves no room at all,  if the market goes up against them, they can either cut it out straight away, or they continue to let the market run against them in the hope that it will bounce back. Imagine you let just one loss run all the way up to £-9.09, you now need to make 5 successful trades of just one tick to recover that loss and put you back into a small profit. This way, if you are 50% successful, and losing 50% of the time, by letting your losses run, you are in big trouble! Your loss will be substantially more than £1 for every 100 trades.

Time to think more like a casino, and how we can apply an advantage to help us with trading.

Previously we were risking 1 to win 1. This method depends on a high strike rate, and users being accustomed to market noise and knowing when to not allow it to push them out of the market. Easier said than done.

So, rather than risking 1 for 1, or even 1 for 2, lets set some boundaries. We’re going to be risking 4 to win 8. This allows for a bit of market noise, so we’re not pushed out of the market straight away.

risking 4 to win 8

Using £100 back bet again at 5.0 for this example. Worst case scenario, the odds move against us, we are getting out at 5.4 for a £7.41 loss no matter what. We are also getting out at 4.2 for £18.10 profit after commission.

Assuming for now we do 100 trades, we win 50 at £18.10 each time, we cut the other 50 out at -£7.41 each time.

Profit = 50 x £18.10 = £905

Loss = 50 x £7.41 = £370.50

Our net profit is £905 – £370.50 = £534.50

By increasing our risk/reward ratio we can also have a much lower strike rate.

Assuming we only predict correctly 30% of the time:

Profit = 30 x £18.10 = £543

Loss = 70 x £7.41 = £518.70

Our net profit with a 30% strike rate = £543 – £518-70 = £24.30

This can be altered, so rather than risking 4 to win 8, you could risk 4 to win 7, and still finish in profit even with less than a 50% strike rate. Below shows 40%

Profit = 40 x £15.47 = £618.80

Loss = 60 x £7.41 = £444.60

Profit = £618.80 – £444.60 = £174.20

 

This is an example to help you get started. You should perhaps play about with this strategy when building your own individual trading plan. When you increase the risk/reward ratio, your strike rate can be smaller, or if you reduce your risk/reward ratio then your strike rate needs to increase.

 

 

 

 

 

 

 

4 thoughts on “Developing a Strategy

    1. Indeed!! The entry point is the biggest edge you have in trading. If your not confident that you’ve got the entry point correct then it’s best to do nothing and re-examine the market for the next opportunity. If the signals aren’t there then you do not trade it.

    1. Yes, a lot of traders like to lay first on the cross-over points. You will find with this that there’s a higher total potential risk when you enter, however the upside is better than the downside.
      e.g. laying at 6.0 first, the increments immediately above go up by 0.2, whereas they go down by 0.1 immediately under 6.0. This roughly works out that the first tick moving up is double the potential spread loss if the odds were to move down.
      I would suggest you put the software into practice mode, and lay at whatever odds you wish at the cross-over points and you will quickly see the potential benefits.

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