Get Your Feet On Earth: Understanding the Difference Between Expected and Real Profits

Yes, we have all committed this mortal trading sin. When we look at a simulation of a trading system and/or portfolio and see a large profit figure it becomes inevitable to start wondering what we will do with all that money and how easy it will be to get to manage millions of dollars with such a good draw down to return ratio. We tend to think that because a simulation gives some results – especially when the simulation is done reliably – those results are “realistic” and “achievable” in real life. However reality is quite different and it is always good to understand the difference between expected and real profit and why it is such a terrible mistake to imagine that a system or portfolio that was responsibly developed and evaluated will eventually yield the results we see on tests.

You are a good trader and you have done your homework. You have developed a system which works only on bar closes, which has wide profit and loss targets and which is live/back testing consistent. You have even done this for a couple of other systems and you have bundled them into a portfolio and achieved the most amazing average compounded yearly profit to maximum draw down ratio. You are obviously thinking now that you’re only perhaps 5 years away from living from algorithmic trading and you are simply filled with joy at all the wonderful prospects that are awaiting you in your near future. What are you doing wrong ?

The problem here comes when we consider that a profit achieved in simulation will be the profit achieved in real trading. You should know that a profit isn’t to be considered “realistic” until it is in fact achieved in real life through the same time length as the profit which was achieved in simulations. A profit which is obtained through reliable simulations is therefore not considered a “realistic” profit but an expected profit. This means that this is the amount of profit you’re expecting to get when you trade your strategy on the real market but you’re not thinking in advance that this will be a fact.

When we develop trading strategies we arrive at profit and draw down figures through simulations which let us know how our system might behave. The draw down (downside) of the system is always a certainty (risk is a fact) but the profit side of the system is not certain (it is probable), therefore you need to consider the profits achieved in simulation as what the strategy might achieve if it does what you want it to do and the risk as what the strategy WILL eventually be losing.

The point of carrying out simulations is NOT to know what profit levels might be “realistic” but to know exactly how much loss we would need to suffer to consider that a system is no longer working and to know how much profit we might EXPECT while this level of loss is not achieved. However this does not mean that a strategy which reaches an average compounded yearly profit to maximum draw down ratio of 7  in backtesting will achieve this value in real trading but merely that while it remains above its Monte Carlo determined worst case scenario, we might expect this profit to be achieved.

Several people have – for example – considered certain profit levels “realistic” because they have been obtained through the reliable simulation of Asirikuy systems within Atinalla portfolios but the fact is that these levels have NOT been achieved in live trading yet (as we need 10 years of trading to validate this) and the truth is that they are NOT realistic profit levels (as they have not been obtained on a live account through a period which matches the simulations) but they are merely the EXPECTED levels of profit while the system/portfolios remain above their Monte Carlo worst case targets. It is therefore irresponsible to say that such levels of profit will be achieved because they are achieved in reliable simulations while the correct thing to say would be that we would expect profit levels on that level OR BELOW while the portfolio remains above its worst case scenarios.

It is always important in trading to realize that simulations are one thing – an invaluable tool which helps us know the long term statistical characteristics of strategies – and realistic long term results achieved on real accounts are another thing. Some people might fool themselves into thinking that such simulations results can be considered “realistic” because a live account trading them would have obtained the results from the simulations but they do not consider that the development of such systems might have been impossible prior to the generation of this data. It is therefore always vital to consider that a simulation is only a tool that tells us the limits of our expectations, exactly how much money we can expect to make and when such expectation ceases to be achievable (when systems fall below worst case values).

Long story short, when developing trading strategies and running simulations of strategies you should consider that what you’re obtaining is merely the magnitude of what you can expect and when you can no longer expect it while saying that a given level of return is “realistic” demands that return to be achieved over a live trading period which matches the simulation (a 10 year live run). It is always good to have our feet on earth and remember that profits are probable and risks are a certainty.

If you would like to learn more about automated trading system development and evaluation and how you can develop systems which deliver accurate simulations please consider joining, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)

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