A reality check - looking at drawdowns

Quite often I meet or correspond with people who seem to think that they can pull a certain amount out of the market on a regular basis. This is impossible - particularly when using a trend following method. 

Depending on your timeframe and parameters, you can easily go weeks, months or even years before new equity highs are made. Therefore, you will actually spend the majority of your time stuck in a drawdown. 

For a lot of people who may be attracted to the potential overall returns of a method, the reality of what you have to go through in terms of drawdowns (both in monetary and time terms) to achieve those returns can be difficult to accept.

I'm just following orders...

Every approach to trading has its own strengths and weaknesses, and often these show themselves when the inherent market direction or conditions (trending or non-trending, stable or volatile) change.

In its purest form, trend following is a reactionary process. You go long when price has started to show strength and made new highs, and go short on weaknesses, and made new lows. Therefore, when markets get choppy, you can suffer small loss after small loss. However, you can also cotton onto new trends far earlier than a lot of other market participants do...

Talking in terms of R - updated

Note: this post originally appeared in July 2014, and has been updated to reflect performance since then.

1R is the amount you risk on each trade. Profits or losses are calculated by taking the result and dividing by the initial risk. For example, if you risk £100 per trade, and you end up with a profit of £500, that's a +5R profit. If you lose £80, that's an -0.8R loss.

Putting all the elements together

Trading, and trend following in particular, can be very simple, but it is not easy. Is it possible to make money trading only a few minutes a day?

Well, yes it is. It only takes a second to click on a mouse and open or close a trade. Good traders will also have already have procedures in place to calculate proper position sizes based on their risk parameters, and identify the ideal entry and initial and trailing stop levels. So the actual process of trading can be carried out in a few minutes each day.

A visual version of tracking trading efficiency

In the Chris Sayce podcast on Chat with Traders, he talks about keeping two portfolios and equity curves - one relating to his actual trading, the other being what he calls his 'Discipline' portfolio, where he is able to track the theoretical performance had he followed his own trading rules to the letter. As he mused, the returns of the theoretical portfolio far outperformed reality. The closer his equity curve can mirror that of his Discipline portfolio, the better his ultimate performance.

This is a visual version of tracking what Van Tharp calls trading efficiency. He advises keeping a log to track your mistakes and quantify them in terms of R. I talked about this here.

Always think about the risk!

Traders are essentially risk managers – your goal should be to ensure any losses incurred are kept as small as possible. While sometimes this means we possibility miss out on some profits, the overriding aim remains that of avoiding big losses.

We have had two instances this week where thinking more about risk rather than potential profits has proved beneficial to us.