The Trading Triangle

Understanding the math of your trading is paramount to developing a trading plan that you can expect earn money over time, or that has a positive expectation. There are three variables that are critical to measure and track to understand how your trading strategy is performing.

Renowned market wizard Mark Minervini (@markminervini) refers to these three variables as the Trading Triangle. This post is dedicated to not only explaining what these variables are, but also some very insightful metrics that can be calculated from them.

It is these derivates of the points of the Trading Triangle that are where the real insights come, as you'll see below!

The Trading Triangle

• Win Percentage
• Average Win
• Average Loss

The reason I really liked Mark's idea to think of these variables as a triangle is it helps to understand that they are all interconnected. If you attempt to change your Win Percentage, it will undoubtedly affect your Average Wins and Losses

Win Percentage

Most newer traders are overly focused on their win percentage. In and of itself, it is a fairly meaningless statistic, but when taken in context of the other two variables, it starts to paint a picture of your performance. The Win Percentage is simply the percentage of your total trades that were profitable.

The reason I say that this stat by itself is fairly meaningless, is because you could have a Win Percentage of 90%, but if you achieved that by stubbornly holding onto to losing trades, refusing to recognize a loss, you might could end up with an Average Loss that is so large relative to your Average Win that you aren't profitable in the long run.

On the other hand, it's entirely possible to have a Win Percentage below 50%, but if you are winning more on your winning trades than you lose on your losing trades, you could be trading a profitable strategy. As you will see, even some market wizards such as Jason Shapiro (@Crowded_Mkt_Rpt), have a win percentage well below 50%, but are extremely profitable over time.

Average Win and Average Loss

The Average Win is the average amount of profit, across all of your profitable trades, while the Average Loss is the average amount lost across all of your losing and break even trades.

To calculate your Average Win take your Gross Profits and divide by your number of winning trades. To calculate your Average Loss take your Gross Losses and divide by your number of losing and break even trades.

While it is fairly straightforward to understand these metrics in and of themselves, the insights really come when you start to see the relationships between each of these variables.

Calculating these in practice

Let's take a sample of trade results. For this analysis, I'll look at a sample of my own trades, that I closed in September. Perhaps the easiest way to quickly calculate these metrics is to separate your Gross Profits and Gross Losses into their own columns. The Gross Profits are easy, they are just the trades that had a positive profit. For your Gross Losses however, you'll want to take the absolute value of the loss incurred so that you end up with a positive number.

Once I've done this, it's very easy to calculate these metrics.

Win Percentage:

• I had 3 winning trades out of 9 total closed trades.
• Thus 3 / 9 = 33%

Average Win:

• Here we can easily see that I had Gross Profits of $5,270.27 and we know it was 3 winning trades.
• Thus we have $5,270.27 / 3 = $1,756.76

Average Loss:

• Again, we can easily see in the table above that I had Gross Losses of $1,771.02 with 6 losing trades.
• Thus we have $1,771.02 / 6 = $295.17

So what does this mean?

So now you know how to calculate the metrics that make up the Trading Triangle, but what does it really tell you?

Profit to Loss Ratio

The first thing to look at is the ratio of your Average Win to your Average Loss. Ideally, you want this to a multiple greater than 1. In my case for the month of September, this number was almost 6. My strategy is centered around trying to let my winners run, while cutting my losers quickly. You can see that in this metric.

You may have noticed that in the Profit to Loss Ratio calculation, we did not use our Win Percentage. For this reason, the Profit to Loss Ratio is nearly as meaningless on it's own as the Win Percentage is. To really understand how efficient and how profitable your trading was, you want a metric that takes all parts of the Trading Triangle into account.

Profit Factor

This brings us to my favorite metric, Profit Factor. Profit Factor can be calculated as Gross Profits / Gross Losses, however I like to think of it as:

Thinking of it in this way, helps me to see it as the ratio of my probability weighted positive outcome to my probability weighted negative outcome. If you have a Profit Factor above 1, then in the sample measured, you were profitable. As your Profit Factor increases, then your profit relative to risk is growing as well.

Peter Brandt (@PeterLBrandt) states that a Profit Factor above 2 is great, above 3 outstanding, and anything above 4 is world class.

Expectancy

Another metric that we can look at that takes uses each of the three components of the Trading Triangle is our Expectancy. The Expectancy is a measure of how what your profit or loss was on your average entry. In poker, we would call this the Expected Value of putting on an individual trade.

This metric is our probability weighted positive outcome minus our probability weighted negative outcome. If we made money over our sample, then our Expectancy will always be positive, and if we didn't, then it will be negative.

I like to look at the Expectancy as a ratio to what you're risking on your losing trades. This tells you in percentage terms, what your gain was, based on the risk you were taking. This would be Expectancy / Average Loss.

Summary

September was a good month in terms of closing a couple of winning trades and keeping my losses small. Thus these metrics look quite good, but there is always room for improvement. I am continually monitoring my performance in these ways, and using my Profit Factor as my guide for how I am doing relative to the risk that I am taking. I think if someone is serious about their trading, they need to have a grasp of these metrics for their own trade results.