The Subjective Function (Part 6)

I unmasked the systems in yesterday’s post (http://www.optionfanatic.com/2012/10/11/the-subjective-function-part-5).  Prior to that I made all my observations about the graphs shown in http://www.optionfanatic.com/2012/10/09/the-subjective-function-part-3.  Once and for all, the time has arrived to select the subjective function.

On one hand, I like a system that trades more and presents more opportunity for profit.  This sort of system has a profit factor (PF) just over 1.00 and grinds out a small profit in each of many trades.  This would be insert #3.

On the other hand, I prefer systems that are surgical in their efficacy. These generate infrequent trades and have larger PFs (e.g. over 1.50 or 2.00).  Ideally, I would like to take advantage of the time one such system is not in the market by trading with another surgical system that is in the market. I am therefore in the market more frequently with multiple systems that each deliver concentrated profits.  I prefer this model.

The risk of using surgical systems to make the equivalent dollar profit as a frequent trading system is that larger position sizing must be employed.  Although the likelihood is that these trades will end up profitable, in case the next trade results in MDD the larger position size could result in catastrophic loss.

I want a subjective function that takes into account both profit and DD.  A system may have had minimal DDs in backtesting but as one author on system development described, your worst DD is always ahead of you.  If the subjective function does not factor in DD then I fear the Risk of Ruin.

Therefore, I will choose RAR/MDD (insert #1) as the subjective function.  By using RAR instead of compound annualized return, I also like the fact that the more a system is out of the market, the more it is rewarded.