5 The Rules
“We have a pretty strict definition of a systematic trader. They basically follow a set series of rules, established in a computer program, that tell you when to buy or sell, how many, as well as when to get out.”
Michael Garfinkle, Commodities Corporation
While the rules taught by Dennis and Eckhardt were not meant as a statistics class, the Turtles did learn some basic statistics including two “errors”:
A Type I error, also known as an error of the first kind or a false negative, is the error of rejecting something that should have been accepted.
A Type II error, also known as an error of the second kind or a false positive, is the error of accepting something that should have been rejected.
If the Turtles made those errors on a regular basis, they would be finished with mathematical certainty. Said another way, they learned that it was better to risk taking many small losses than to risk missing one large profit. The concept of statistical errors was an admission that acknowledged ignorance could be quite beneficial in trading.
At the root of Dennis and Eckhardt’s statistical thinking was Occam’s razor (a principle attributed to the fourteenth-century English logician William of Ockham). In more contemporary jargon people express it as, “Keep it simple, stupid!” For Dennis and Eckhardt’s rules to work, to have some statistical reliability, they had to be simple.
Expectation: How Much Does Your Trading Method Earn in the Long Run?
“What can you expect to earn on each trade on average over the long run from your investing decisions or your trading rules?” Or, as a blackjack player would say, “What is your edge?” A first step for the Turtles was to know their edge.
A good analogy is being a batter at the plate in a baseball game, as trades and success rates aren’t much different from batters and their averages. Dennis expanded on this: “The average batter hits maybe .280 and the average system might be successful 35 percent of the time.”
More importantly what kind of hits did you get in hitting .280. Did you hit singles or home runs? In trading, the higher the expectation, the more you can earn. A trading system with an expectation of $250 per trade will make you more money than a system with a $100 per trade expectation (all other things being equal in the long run). The Turtle rules themselves had a positive expectation per trade because their winning trades were many multiples larger than their losing trades. Expectation (or edge, or expected value) is calculated with a straightforward formula:
E = (PW X AW) - (PL X AL)
E = Expectation or Edge
PW = Winning Percent
AW = Average Winner
PL = Losing Percent
AL = Average Loser