Monday, June 25, 2012

Potential vs reality

I can post hundreds, if not thousands of charts showing recent profitable trades based on my own system rules, but at the end of day, the system will only give YOU the profits it can generate if:

a) You can stick to the signals, no questions asked;
b) You have the right state of mind to put up with the inevitable periods of drawdowns;
c) You have clearly defined risk management parameters that you can fully adhere to.

Overriding signals can stem from giving a losing trade extra leeway (because you don't want to 'bank' a loss) to failing to follow an exit signal given on a profitable trade, thinking its a small pullback (it may well be, but then again, it may be the start of a reversal of trend). Also, seeing signals but not acting on them is just as damaging. Flicking through interviews such as those in Market Wizards, some of the most bizarre system signals caused some of the biggest winning trades. As an example - long signal on heating oil in the middle of summer???

Trend followers, indeed all traders, have periods where losses accumulate and profits are hard to come by (for trend followers, this can be when there is a lack of direction in the general market, and/or high volatility - other types of traders would profit from these market conditions). This can place doubt in your mind about the validility of the system being used, and set you off onto the next system to try. Remember, there is no holy grail out there.

These periods of drawdowns also give validity to the risk control you use, in that you must ensure you remain in the game, to take advantage of those periods that do suit your trading style (for me, that would be a stable, trending market). In addition if you are closing losing trades before they have hit your stops, then that would indicate that you are unable to let the trades play themselves out. Stop placement is an integral part of the system, and you must adhere to it at all times. Funnily enough, making profits also validates your risk control - if you are too eager to take profits off the table before you get a suitable exit signal, that may well also indicate that you are trading too large a position and are frightened to seeing those profits evaporate. The simplest way of achieving this is to trade a small position relative to your trading equity - 1% - 2% is the norm.

To conclude, until you are fully 'compatible' with those three aspects of the system you are following (be it trend following, day trading, scalping or any other method you care to name), you will never achieve the results that any trading system potentially will give you.

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