Saturday, December 28, 2013

Refining your approach - learning from losing periods

When trading using a trend following approach, it can be easy to get disheartened if, after starting using the method, you quickly encounter a run of losses. I referred to this topic here.

The prevailing market conditions when you start using the method can greatly influence the initial results. Some may get lucky and put on a few trades which coincide with a nice trend in the general markets. As a result, they are more likely to get some overall positive returns. 

On the other hand, if you try to put on a few positions when the markets are rangebound, experiencing a higher level of volatility, or are trying to reverse trend, then things may be a lot of more difficult. If you are one of those traders, then you are highly likely to incur a run of losses during this period.

The prevailing market conditions will, to some degree, have an effect on individual stocks. In recent yesars, we saw this best in 2008, when even the strongest stocks both from a fundamental or a price action point of view got dragged down.

Your preferred timeframe will also be a factor - generally, the shorter-term the entry and exit signals, the earlier you will get into a new trend, and the earlier you will get out of a completed trend, but you will be more prone to whipsaws or market noise. The longer-term the system, the wider the stops and you will be entering a new trend later than a lot of market participants, Again, the parameters you use will determine this, and you would have to accept that they will not suit all market conditions.

And this is before you even look at whether you have any mistakes in implementing such a method. Have you calculated your risk incorrectly? Have you put on too many trades when market conditions are unfavourable? Did you exit a losing period too late, hoping it would go back in your favour? Did you take a small profit on a trade, for fear of losing it? Going through your trading records and reviewing charts of previous trades will help identify any of these issues.

The people with the best chance of success look upon such periods as learning experiences, take on board what they have learned, and move forward. Quite often, any changes they make to their approach will be minor, and may relate for example to interpreting the general markets, not the nuts and bolts of entry and exit signals, or risk parameters.

I think of the two traders who have been part of my mentoring programme the longest. The first, who I talked about here, literally went straight into a drawdown from day one. The weekend I met him marked the top of the market uptrend that had been in place for a while. He was in that drawdown for about 4 or 5 months. 

However, in that time, he learned the benefit of reading the trend of the market (not just of individual stocks), as well as ironing out a couple of issues he had with his stock selection. This period also reinforced the notion of having good risk control, and was the start of him developing the necessary mindset. He has not looked back since those opening months. In reality, that period was his 'tuition fee', while his equity was at its lowest level.

The second trader was more fortunate in the sense that he started when the markets were in a bit of a trend, and consequently was able to get into some profitable positions early on. However, he then had a sticky patch a few months later, when the markets were less than co-operative, and were actually trying to change trend. 

A review of his trades showed that, in sub-optimal conditions, too many trades were being opened. He has learned from this. In a similar situation a month or two back, his approach was the polar opposite. He was very lightly invested, and was using his patience to wait for when the odds were more in his favour. Again, he had learned from his losing period, and is now getting rewarded.

If you do get into one of these patches, then you need to study and learn from them. It is in these periods where discipline, consistency and risk control come to the fore. Then, when conditions become more favourable, you will start to see the results start to turn around. 

Trades that previously started out in profit, before falling back and ending up at break-even or a small loss, are now holding up better. Drawdowns get reduced or eliminated. Your confidence levels will start to increase. You will see how, once you get into one or two trades where a trend takes off, how quickly losses can be overcome. At the same time, you will learn the importance of letting those winning trades run. 

One trade generating a 10R profit can eliminate a whole bunch of losing trades in one go. And then, when the next market phase develops that is not the most conducive to generating profits, you will be able to recognise the warning signs, and be better equipped to deal with it.

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