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April 23, 2012 / ougnt

Setting cut loss position using Profit/Loss ratio.

Let P = a probability that a trading gain profits.
So the probability that  the trading loss is 1 – P.

Let E =an average capital gain
and L = an average capital loss

The overall profit  ( OP ) = ( P x E ) – ( ( 1 – P )  x L )      ………(0)

Now the overall profit equation is deal with three variable.

If OP > 0   ===>   we can survive in the cruel market.  ………. (1)
If OP <= 0    ====>  It is a time to adjust our trading decision. ….(2)

It sure that we need to stay survive in the market so we focus on (1)

OP > 0 
or
( PE ) – ( ( 1 – P )L ) > 0     …….. from (0)

Assume that we can control that E = 3L
or
average profit is equal to three time the average loss

so

3PL – L + PL > 0
4PL – L > 0
4P – 1 > 0   *
4P > 1
P > 1/4  …………….(4)

From (4), we can see that if we can control the average gain to three time of the average lost, the probability that we buy a right stock = 0.25 is enough to be survive in the market.

Now, the new question is how to control the average gain/lost.

Let’s see.
If a stock A’s price is 100
We expect that the price should be 130 ( from fundamental or technical or whatever )
So the maximum profit = 30
Then we set the cut lost point to 10 point ( E = 3L )
The cut lost point is 100 – 10 = 90

The last thing to do is make our probability to buy a right stock to be more than 25%. Is it so hard?

* because L is always a positive number so we divide  both side of the inequality equality

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