Impact of Randomness

Assume a trader makes 500 trades in a certain year, with a win rate of 55%. Each trade has a symmetrical payoff (win 1%, lose -1%) and the capital at the beginning is 100.000 USD (Probably a much better setup than most retail traders have).

To illustrate the outcome of such a scenario, I have conducted a 1000 simulations of that experiment. This can be interpreted as 1000 traders starting at the same time, with the same capital, while being exactly identical in terms of their trading skills. The only difference is if they win or lose on a certain trade (drawn randomly from urn, placed back and repeated).

On average, the traders generate a yearly return of approximately 60%. More interesting is the large dispersion influenced by chance. 21 traders out of 1000 suffered losses because of that, despite their skill.

Same experiment, but done over a period of 5 years (2500 trades), shows that every trader made good money. Effects of luck or bad luck disappear over the long-term, making skill the main factor. Therefore, the angle of the equity curves in the logarithmic chart should get quite similar over time.

Key points:

  • In the short-run, randomness has an enormous impact on the outcome. Even if you are a very good trader, a losing year might happen to you, so plan accordingly.
  • Over time, the effect of randomness disappears and skill becomes the main driver of good performance (probability theory: the law of large numbers).
  • It is impossible to judge if a trader or a strategy is good/bad based on a small dataset. Remember that this is a long-term game.


About me

Former hedge fund portfolio manager/trader

15 years of experience in financial markets

✓ Master of Science (MSc) in Business and Economics from the University of Basel

✓ Developed quantitative tools for an asset management