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 there 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.