The house edge

Las Vegas 2015
What happens in Vegas, stays in Vegas. (Las Vegas, 2015)

In a casino you want to be the house not the gambler. Think of the house edge. The more people come to play, the more a casino can take advantage of its statistical positive expectancy. I hadn’t put much thought to it until couple of years ago a backtest clicked to me.

A smaller edge with higher trade frequency

In 2020 I completed a backtest for a strategy applied on the S&P 500 index VS sector indexes. The profit factor was in favor of $SPX with 7 (for every dollar lost it made $7 which is excellent), sector indexes got a profit factor of only 2. However, when I compared the gain of R multiples (meaning how many times of my risk per trade did it make), then the gain of $SPX was 7R whereas sectors gained 45R. The strategy was over 6 times more profitable applied to the sectors. Why? Trade frequency comes into play. There was more opportunities in sectors than just one instrument. $SPX had 8 trades and sectors had 163 trades in the same time period. Trading fees were included in the backtest, slippage was not.

Limiting expected losses

Of course, first you need an edge to begin with. Otherwise, increasing trade frequency would be deadly for the trading account. Secondly, a strategy needs to overcome trading fees and still remain profitable. This is something inexperienced traders sometimes miss in their backtesting. But other than high turnover frequency, a casino also limits the size of bets for a reason. This is why you’d see a dollar limit at the blackjack table, because the house wants to limit losses and let probabilities play out in their favor without risking too much on a single loss. This is how my own day-trade system operates. According to statistics from the backtests, it has the smallest edge of my trading strategies in terms of performance metrics, but the highest annual return rate. I don’t allocate too much capital to it yet, cause I’ve been running it for a few months only.

Rolling with the punches in a harder environment

Since my account is mostly in cash (USD) and only short-term systems running, I checked how the first half of 2022 has been going for new trades opened this year, excluding trades from 2021 that gave back some open profit in January dragging down the YTD performance, although being profitable trades individually. So this year alone I’ve had 364 trades, which is much more compared to previous years due to the day-trade system. This is also increasing volatility with the expectation for higher returns. Summing up, my trades in 2022 account for -4% of the portfolio in USD and +5% in EUR at the time of writing. So most of the YTD drawdown has come from last year’s profit giveback. I’m not trying to ignore the rolling YTD drawdown, but looking at the current situation unfolding in the markets, I think I’m doing fine.

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