Tuesday, September 17, 2013

The road to refinement

The beauty of trading is that, no matter how well you may have performed in the past, you can always improve. Whether this is by tweaking your basic strategy, improving your execution or your risk control, a successful trader always looks for potential refinements. Some of these changes can be brought about a change in the market, or in your own psychological make-up.

The biggest improvement I have made in recent years came from the frustration of suffering a drawdown in 2011. I found that my trend following method struggled in that year. The increased volatility, coupled with numerous failed breakouts in the general markets, meant that too many winning trades ended up turning into losers, and quite a few trades never really got going in my favour, before suffering a slow and painful drop to a full 1R loss. 

Historically, pure trend following systems can suffer prolonged periods of drawdowns when encountering a series of losses. What I wanted to do was find a way to minimise the losses incurred, without impacting upon the profits generated in my successful trades.

Above all, I knew that, for any change to be successful, it must make sense to me, be simple to understand and implement, and I needed to be 100% comfortable with what I was trying to do.

I spent several months simply thinking about how I could get around this. As people who have read this blog for a while will know, I subscribe to the KISS method (keep it simple, stupid!), and when I finally came across my solution, the simplicity was striking. The change revolved around my use of stops, and is detailed in the addendum to my e-book.

Now, with this change I generally cut losing positions much earlier. Some of these losing trades subsequently turned round back in the direction I was trading. As a result, I missed out on those profits. But, I wasn't concerned so much with the next trade, or even the next ten trades. I was more concerned with the next 10,000 trades. The smaller losses taken, and the overall compounding effect on my account convinced me it was the way to go.

The changes were implemented into my system in the summer of 2012, and the resultant performance is shown here. The results have shown a subtle change in my performance statistics achieved. 

Historically, my win ratio was almost exactly 50% - this has now dropped, and is now in the region of 43-44%. Against that, the profit factor (average win size divided by average loss size) has increased. Therefore, the overall expectancy has slightly increased. More important to me has been the psychological benefits of controlling losses and potential drawdowns better than before.

My stop methodology could be difficult for other traders to follow - they may not like the idea of cutting losers so quickly, and will give them additional leeway. My response to this is that every big loser starts out as a small loser. So what if I close a position I opened a matter of hours ago? I want my trades to act correctly as soon I open them. 

While my system is not a holy grail in the accepted sense, it is my personal holy grail. I know that, if I stick to the rules I constructed, I can make decent profits, while controlling my losses. And that is the holy grail for any trader.

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