Wednesday, April 04, 2012

Being comfortable with your losses

You can learn a lot both about your trading system and your compatibility with it during those periods where you suffer a drawdown.

In these periods you will quickly find out if you are comfortable or not with the individual losses you incur, and the overall drawdown you suffer – that will give you a clue as to whether you are trading too large a position relative to your equity. In addition, if you are using a trend following system, you will also find out if you are comfortable with the process of coping with the “bend at the end of a trend” (the giving back of profits before an exit signal stops you out of a position) that all trend followers have to endure.

Remember that a complete trend following system ensures that stops are properly placed to limit your risk to your preset parameters. You should NEVER move a stop further away from your initial entry point, hoping to give a position a bit more leeway before starting to move back in your favour. That immediately flouts your pre-set risk parameters, opening up the possibility of a loss running away from you.

If you are a UK resident and spread-bet via IG Index, you can avoid the thorny issue of gaps through your stops by using the ‘controlled risk’ guaranteed stops in your position, meaning that you can fully quantify your absolute risk at all times, without having to worry about gaps and/or stop slippage in fast moving markets.

Although my current year to date performance in my standard system is showing a negative result, I am quite comfortable with this. Of course, I would like it to be positive, but as mentioned in a post earlier this week, I did not trade the early part of January, which was the best time to enter long positions given the breakout to the upside in the indices.

Due to the lack of direction since mid-February, and the looming possibility of being given a sell short signal, I have been stopped out of a number of positions, meaning that as of this morning I am now only in one long position in my standard portfolio. This also means that my exposure to the market has reduced. This will increase, and new positions will be opened, when a new entry signal in the general indices is given.

Remember also that historically trend following systems have been used to trade foreign exchange and commodities as well as stocks and indices. A well designed trend following system should be robust, giving you the opportunity to trade these other markets, ideally with no changes to the system parameters. Therefore, you still have the opportunity to trade markets such as gold, oil, and the major forex pairs while the stock market makes up its mind before making its next move.

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