Thursday, May 16, 2013

Which scenario do you fall into?

Would you want to limit yourself to a lot of small gains, and be prepared to suffer the occasional large loss?

Or would you be prepared to have lots of small losses and wait for the occasional large profit?

To achieve the first, this can only occur if you have stops that allow the losses to greatly exceed the win sizes. You are therefore reliant upon having a very high win percentage to make money over the long run. The problem occurs if this sort of system starts to suffer a series of losing trades, or maybe even a single loss far outweight any previous large losses. This almost certainly leads either to a significant drawdown or even an account blow up. The problems become even more acute if you are risking too much per trade, relative to your equity.

In the second scenario, losses are kept to a minimum and the profitable positions are left to run. These trades, when they do come along, cover all the small losses, and generate an overall profit.

I have had the pleasure of speaking to another trend following trader in Canada, who has created a system to trade commodities and foreign exchange. He used extremely tight stops, and incurred a high number of consecutive losses using the system. Fortunately, he uses good risk control and was aware that he could suffer such a run. Then, he got short signals in both gold and silver a few weeks back. Just those two trades alone have generated mammoth profits, leaving him nicely in profit.

Anybody serious about trading will want to put the odds in their favour as best as possible. They would want to limit their losses, and to ensure they do not limit their profits. Unfortunately, there are a lot of traders who seek comfort in a high win rate. Calculating the overall expectancy of your system over a reasonable number of trades will guide you in this respect (refer to this post from 2010 for more).

As Bernard Baruch said "If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong."

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