Adverse Excursions Part 3, A Risk Reward Indicator, 08/16/07
[Note: The current indicator forecast is here...]
A crude risk/reward indicator can be constructed by taking the ratio of expectation to adverse excursion over the next n days based on a best estimate of the current market conditions:
An indicator value greater than one means the average expectation is greater than the average adverse excursion.Here is a look at the indicator for the S&P Futures for 8/16/07:
An indicator value less than one means the average adverse excursion is greater than the average expecation.
And a negative value means the expecation is negative.
Explanation: For the 5 Day Risk Reward, a ratio of 0.4 means that there are, on average, 2.5 percentage points of adverse excursion for every percentage point of expectation.
5 Day Risk Reward 0.4 10 Day Risk Reward 0.6 20 Day Risk Reward 0.7
The problem, of course, is 'current market conditions' which are subjective and make the risk reward indicator a bit more like a weather forecast than a precision tool: the better the forecaster the better the tool.
Usage: This indicator can be used to turn mechanical and discretionary trading systems off when the risk reward parameters become too negative for them to operate. The individual components of the indicator can be analyzed against stop parameters for further confirmation of on/off signals.
(Parts 1 and 2 of this series are here and here.)