Reason you can profit even with a 37% win rate - Japanese Stock System Trading Basics Course Part ④

Reasons why you can still be profitable with a win rate of 37%

I am Takeshi Nishimura, a securities analyst and seminar lecturer on system trading at Fair Trade Co., Ltd. In this course, I will explain in simple words and expressions so that everyone watching can understand “system trading” from the basics. Please stay with me until the end.

This time's theme is “Reasons why you can be profitable with a 37% win rate.” Now, let's get into the details. In the breakout course for “37.1% win rate,” we conducted our first backtest (verification) using a simple channel breakout method. By analyzing past data, you can quickly learn whether the method has effectiveness in system trading, and I hope you will find it somewhat appealing. Therefore, in this session as well, Mr. Masakazu Saito will explain the trading rules.

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This is Masakazu Saito. This time, based on the backtest results of the breakout with a 37.1% win rate, I would like to perform a slightly more detailed analysis.

First, let’s briefly review channel breakouts. Below are the trading rules for channel breakout (40-day breakout).
  
┌───────────────────────────────┐
[Buy rule] - Update the high price of the past 40 days (the highest close)
[Sell rule] - Update the low price of the past 20 days (the lowest close)
Note: Trades are executed at the next day’s opening price └───────────────────────────────┘

Next, the verification results when trading according to these rules are as follows.

┌───────────────────────────────┐
[Verification results] (Test period: 2000/01/01–2008/05/16)
Win rate: 37.1%
Average profit and loss rate: +0.89%
Average holding period: 49.94 days
└───────────────────────────────┘

As explained in the breakout course with a 37.1% win rate, the average profit and loss rate is +0.89%, so it is at least positive. In other words, the more you trade, the more you can profit with this rule. Some may feel a conflict with the idea that a rule can be profitable with only around 37% win rate. Now, let me briefly explain why it is profitable.

For example, if you repeat five trades with results as follows, what would be the overall performance?

┌───────────────────────────────┐
1st: Lose -10% 2nd: Win +20% 3rd: Lose -10%
4th: Lose -10% 5th: Win +20%
[Result] 2 wins 3 losses (win rate: 40%)
Total profit/loss: +10%
Average profit/loss: +2% (+10% ÷ 5 trades)

└───────────────────────────────┘

As shown here, even though losses outnumber wins, the total result is profitable. This is because the profits when you win are larger than the losses when you lose. In other words, the win rate, in practice, has little real meaning; what matters is whether the total profit and loss is positive.

And the channel breakout method belongs to this type (where profits on winning trades are large). Now that the average profit was positive in the backtest of the breakout trading method used in the “37.1% win rate” course, it means the rule becomes more profitable the more you trade. But let’s take a closer look.

I apologize for the lack of graphs, but around the year 2000, when this trading rule began, the market was in a historic downtrend, and it continued to fall almost unilaterally until roughly spring 2003 when the Nikkei index touched the 7000 level. In such a market, using the channel breakout method would have caused assets to keep shrinking. On the other hand, from spring 2003 onward through late 2005, the rising market saw substantial profits.

In other words, with this method you can profit in rising markets and incur losses in falling markets. However, one more point to note is that the profits in rising markets are far larger than the losses in falling markets, so “profitable in the long run” seems likely.

As long as the market does not fall indefinitely, the profitability potential remains high, but relying on this as-is might be a bit insufficient. Therefore, in this course on “raising effectiveness by 4% win rate,” we will apply a small modification to this channel breakout method to create a more usable rule. Please also take a look at that.

Masakazu Saito

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How did you find Masakazu Saito’s explanation of the trading rules?
That concludes the reasons why you can be profitable with a 37% win rate.