Friday, February 01, 2013

Rolling with the punches

One thing you have to deal with as a trader is the fluctuations in your fortunes, as well as your equity. Even with strict risk controls, you are still able to suffer drawdowns following a string of losses.

As a trader, you are only playing the probabilities - you try and stock the odds in your favour, and place your bets. Even with such an edge, you can still suffer losses, whether as a result of catalysts such as earnings reports or trading updates that are poorly received, fluctuations in the indices, or generally just where existing trends decide to end, which leads to a loss of open profits. When coupled with positions that end up being losing trades, then your equity curve can take a hit.

The last week was been disappointing for me in that not one, not two but my last EIGHT trades (which have been put on since early January) have all generated losses.

If those same eight set ups were to appear again, would I put the same trades on? Absolutely - they all met my criteria, exhibit the same set up on the charts, and were in the same direction as the general market trend. There would be no reason not to trade those positions. Having said that, there are other stocks that exhibited the same characteristics, which I did not take positions on, that have done very well. Such if life. This is why trend following is not for everyone, and psychologically can be difficult to stick to.

Remember that a trend following method historically has a win average of approximately 40%. If you get it up to 1 out of every 2 trades, you are doing well. Around that, you can have peaks of over 70%, and troughs of less than 30%. You have to take the rough with the smooth. It you can't, then trend following is not for you.

Periods like this are also why I have an overall limit on the number of trades I can have open at any time (denoting my overall portfolio risk or 'heat'), as well as limits on the number of positions I could open on any given day. If I did not, then I may have incurred more losses over the last few weeks.

People often seek solace in a high win ratio, with normally means small winners with the occasional large loss. Trend followers look at it from the opposite direction - a lower win rate, but with controlled losses and unlimited profits. This is what gives it a positive expectancy.

As a result of all this, I am now very lightly invested. I will simply wait for new setups to emerge, and will trade them accordingly. Who knows, the next eight trades may recoup those losses and more...

2 comments:

  1. Hi Steve. As I'm writing this post I'm with a 19,5% winning rate (80,5% losers). Yet, my winners are 4,68x the size of my losers which makes my system to have yet positive expectancy. Hope the rate will get closer in the future to the 40% average for trend following systems. I pyramid whenever the price movement allows it to, which makes the stops to rise when new units are added (don't know if the 40% average winning rate considers pyramiding...). Does it?

    Nice website.

    Best

    João.

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  2. THanks for the comment. The 40% average is the typical win rate across the whole trend following spectrum. As a rule I do not pyramid, yet others do quite aggresively. Curtis Faith in his book Way of The Turtle talked about the Turtle traders using the 'whipsaw' method with very tight stops (0.5R) allied to the aggresive pyramiding that they used. This sounds quite similar to what you may be doing - it reduces the win rate, but makes the potential wins a lot bigger.
    Of course, looking at the monthly performance numbers of those traders, they showed quite wild swings (in percentage terms) from one month to the next. Horses for courses...

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