Sunday, November 8, 2009

Measuring System Vulnerability : The Market Exposure Index

If you have been reading my blog for a while you may be familar with my use of the term "market exposure", as a matter of fact, most of you may be aware that this is a concept I use most the time to describe trading systems and gauge their possibility to be long term profitable. But, what is exactly market exposure and more precisely, how can it be measure ? Well, those of you who are subscribed to my newsletter may already have seen the video I posted on the FTP about market exposure and how this is vital for the description of a trading system. However, since this concept is pretty important and mentioned throughout my whole website I have decided to dedicate today's post to the analysis of the concept and the formal introduction of what I like to call "market exposure index".

The first thing we need to do if we want to talk about market exposure is to define it. What is market exposure ? There are actually several ways to explain the concept but the simplest one is to think about market exposure as the magnitude in which your system becomes vulnerable to loses as a consequence of the opening of a position. That is, whenever you open a position in the market you are getting "exposed" to losing your money as the market can take a move against you. The vulnerability of any system against taking loses is what I call "market exposure".

Now that we know what market exposure is we are left with a more challenging task. How do we measure market exposure ? How do we measure the vulnerability of a trading system against the market ? The first thing we need to do is think about the factors that affect market exposure, what affects the exposure of a system against the market ? The most important things that determine market exposure are the system's risk to reward ratio and the overall winning percentage of the EA. That is, the probability to win a trade. You must take into account that these two variables have to be deduced from extensive historical or live testing as short tests could bring unreliable results. Also take into account that the probability to win a trade, is never 1, that is, there is ALWAYS the possibility to lose a trade. Stubborn systems, like grid trading systems that assume the market will always "come back" to achieve a profitable result eventually lose as, even though the probability to lose can be low, it is still present and the fact that you are putting your whole account balance at stake makes the system to eventually wipe your account.

So how can we measure market exposure ? This is the reason why I came up with what I call, the market exposure index. This quantity, which is expressed by a simple mathematical formula can tell us if the market exposure of a system is capped. The formula is very simple

market exposure index = 100*(fraction of losing trades)/(average reward to risk ratio)

For example, the god's gift ATR, GBP/USD has a market exposure index near 60. Any market exposure index below 100 implies that the strategy is profitable and adequately capped. Any result above 100 indicates that the system is unprofitable, the higher the market exposure index, the higher the risk of a wipe out. For example, Martingale systems, whose risk to reward ratio increases exponentially with every losing trade have a market exposure which is generally equal to equity over the fraction of profitable trades. Grid trading systems have the same risk to reward ratio, something which lets us know from the start, through the market exposure index, that those are strategies with very important market exposures that WILL cause account wipe outs in the long term.

Hopefully, if you liked the idea, you can start using the market exposure index as a way to gauge the viability of trading strategies and the way in which they protect your equity from the market. Strategies with very low market exposures are the best since ideal strategies would have a very low risk to reward ratio with a very high winning probability. Most of the time, the best systems have a compromise between these two things.

If you would like to learn more about trading systems I have developed and how you to can evaluate and trade automated systems profitably please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !

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