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After
researching position sizing™ strategies for a number of years, Dr.
Van Tharp developed a proprietary measure of the quality of a
trading system that he calls the System Quality Number or SQN.
SQN measures
the relationship between the mean (expectancy) and the standard
deviation of the R-multiple distribution generated by a trading
system. It also makes an adjustment for the number of trades
involved. Dr. Tharp has determined that the better the SQN,
the easier it is to use various position sizing strategies to meet
one’s objectives.
The
calculation, use, and interpretation of the SQN are discussed
extensively in Dr. Tharp’s book, The
Definitive Guide to Position Sizing.
In addition,
Dr. Tharp discovered that when he applied the SQN formula to the
daily percent price change of a stock or an index, it proved to be
an excellent measure of trendiness. Dr.
Tharp now calculates a market SQN for the S&P 500 based on the
daily changes in the S&P 500 for periods of 25 days to 200 days
and publishes the results each month in his free newsletter Tharp’s
Thoughts. Dr.
Tharp’s monthly Market Update includes a graphical representation
of the market SQN for 100 days that makes it easy to see how the
market is performing. Dr.
Tharp also uses a quantitative world model of the markets that shows
the strongest and weakest regions, countries, sectors, and
currencies using the universe of ETFs. Dr.
Tharp’s multiple analytical perspectives provide readers a
holistic view of market conditions and help them understand how the
market is likely to perform in the short term.
Below we will add
questions about SQN from our readers.
Minimum System
Quality Number
Q: Can you advise
as to what the minimum SQN would need to be for a system to have a 90% chance of its return
being twice as big as its drawdown over a 100 trade period? For
example, a 10% chance of a 25R drawdown and a 90% chance of 50R
profits over 100 trades. I can then use position sizing
methods to get
the results that I am after.
A: First, there
is no minimum SQN to have a system return twice as much as its
drawdown. You can do that with high SQN systems and acceptable SQN
systems. "Returns twice as big as a drawdown" is an
example of an objective and you achieve your objectives through
position sizing, not through your trading system. Your trading
system needs to have a positive expectancy, but it is the SQN that
determines your potential effectiveness and efficiency in applying
position sizing strategies to meet your specific objectives. For
systems with higher SQNs, you will find your objectives easier to achieve, you
will have more flexibility in choices, and you will be more likely
to meet your objective through position sizing methods. To learn more, I
would recommend reading the Definitive Guide to Position Sizing
in which I provide a full explanation of the SQN and explain a
multitude of position sizing strategies. A number of readers have
replied to us that the book completely transformed their trading by
changing how they thought about trading systems and position sizing
strategies.
The best traders apply
their deep understanding of position sizing methods to a good SQN system and
combine that with the proper psychological mindset to make great
returns in the market. You can learn to do that too with a strong
commitment and the proper training. I wish you the best of luck.
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