Risk Reward Indicator FAQ, 9/15/07
Is the 'green' indicator forecasting positive expectation?
No. A 'green' indicator is saying that the risk/reward profile is positive which means that the distribution of winning trades for a given trading system/methodology will tend to win more and losing trades tend to lose less over time under this profile than they would under a neutral or negative profile.
Similarly, a yellow indicator is saying that the distribution of losing trades will tend to lose more over time than they normally would under a neutral or positive risk/reward profile.
The red indicator is only one of the three that forecasts negative expectation.
The key is to remember that the indicator is talking about the distribution of returns under this profile and forecasting how that distribution will be skewed.
What are the problems with the indicator?
The biggest problem is that, from an optimal money management point of view, you're better off taking all of the trades and trading them at optimal leverage in a system/methodology that has a positive expectation. You just can't pick and choose your trades or hand pick the leverage for each individual trade - the standard deviations are too great. Given that most of us still do this, it's useful to have a countable methodology for making those decisions.
The other problem with the indicator is that is based on outputs from my forecasting model which is discretionary, meaning I pick and choose the inputs. If those inputs are incorrect, the indicator will be incorrect.
Have you back-tested the indicator?
A Risk Reward Indicator for S&P Futures, updated after market close 07/13/07:
5 Day Risk Reward 0.0 0.3 10 Day Risk Reward -0.1 0.4 20 Day Risk Reward -0.1 0.9
Would you recommend indicator building?
I recommend forecasting - it is quite helpful. An indicator is just the formalization of a forecast. Forecasting a path for the market beyond one's normal time horizons provides invaluable perspective.