Your goal is to maximize your profits and thus your return on your trading capital. But how do you know if your trading is truly optimized or if there is room for improvement and more money to be made with it? If it could be better, is it you or your system and how can you tell?
Trading systems, like automobile engines, are never 100% efficient and there are parallels between the two that can be useful to you. There are many concepts from Mechanical Engineering which can be utilized in Trading. One in particular is the Carnot Cycle.
The ultimate engine would convert every joule of the chemical energy in the fuel to work as that is the engine's primary purpose. In the real world, a certain amount of that chemical energy is lost to heat, friction, entropy and other inefficiencies.
For any given trading system executed perfectly, there will always be a certain percentage of trades that are not profitable and a certain portion that are. Additionally, most systems are based on lagging indicators and even "predictive" systems still rely on historical data. No system out here will pick the exact top and bottom of every market move, so the size of actual gains and losses is also a factor in the profit potential. So how can you tell what is the true potential of your trading system?
Back in 1824 Nicolas Leonard Sadi Carnot developed a thermodynamic model called the Carnot Cycle for engines which provides the maximum output that can be expected from any given type of engine. For example the Carnot Cycle for a diesel engine shows the absolute maximum work output that any diesel engine could attain.
This thermodynamic model was and is particularly useful for combustion engine design because in very clear mathematical terms, the Carnot cycle represents the ideal cycle possible. It clearly identifies and illustrates the greatest achievable efficiency for a given engine type.
Even a perfectly designed and manufactured diesel or gas engine can only hope to achieve the efficiency of the Carnot Cycle as calculated in the thermodynamic analysis. There will always be losses due to heat and entropy.
Fuel efficiency in automobiles has substantial consequence to all of us both direct and indirect as it impacts the cost of transportation for both ourselves and goods we buy.
Efficiency in Trading also has both direct and indirect consequence as it impacts both our account and our quality of life. Profitable trading provides monetary rewards and personal gratification, while inefficient trading can have a severe negative impact on our self-esteem and our quality of life.
Like the Carnot engine, you can determine the maximum potential for your trading system through backtesting it under ideal conditions, when every trade is executed perfectly in the market of your choice according to the rules and indicators of the system. Since most systems and software make use of lagging indicators, it is important to make sure that during backtesting you trade the system exactly according to the system.
During this process, you can make determinations that have direct financial benefit:
- what the true maximum profitability is for your system
- you would have a baseline or reference point for long- term planning for your trading.
- see if you've had reasonable or unrealistic expectations for your system and your profitability.
- if you find that your system is not capable of results that are satisfactory to you, then you need to look at possibly modifying or replacing your chosen system.
- if your system is capable but you haven't been seeing the results you expect, then you know to look for opportunities for improvement in how you trade.
- if you find that you've been making specific mistakes due to emotions influencing your trading, then improving your emotional management would be the most likely way to have a substantial impact on your results.
A focus on continuous improvement is a mindset and practice that has direct financial rewards for traders that pursue it.
Regardless of the markets you trade or the system you use, emotional management is imperative to realize the most from your trading, as this is one of the most common inefficiencies.
In Trading, inefficiencies are losses and missed profits and add up considerably over the course of a year. Having a clear understanding of what your system's possible best is, then identifying those inefficiencies in your trading is empowering and rewarding both financially and personally.