The ‘three Ms’ of trading have been referenced many times in our trading blog; our mindset, money management and method are the three critical constituent parts that underpin our overall approach to trading, these three critical success factors are then imprinted in our trading plan which (as we’ve mentioned on numerous occasions) is never violated, only changed when the situation arises.
Many would argue that the method part of our overall trading strategy is the least important of the three Ms, given that traders (in theory) could select many methods that ‘work’. And as we’ve stressed many times a strategy only needs to deliver up winning trades 50% of the time, with an R:R greater than 1:1, to be successful if the money management is tight. Despite the continual discussions as to which ranks highest, we’ve gone to considerable lengths over the years to suggest that each part of our three Ms ranks equally…
As we’ve mentioned earlier the method needs tight money management > which in turn requires discipline in the form of a strong (yet balanced) trader’s mindset > a mindset that can come under intense stress > when our method looks is as if it’s failing…
As you can see from that sentence all the key parts of our trading plan are intrinsically linked. So how do we decide if our overall method/strategy is failing. Are there any key metrics we can use to help us make that decision? Or, if the method is failing, does that suggest the money management and the mindset might be equally failing?
In this article we’ll concentrate on the method exclusively and suggest various ‘stress tests’ we can subject our method to in order to establish if the method needs replacing. In this journey we’ll also discover if we’re being far too hasty in putting the current method into the trader recycling bin.
Have we stuck to the trading plan?
We can’t stress enough how failing to stick to the trading plan can be fatal to all 3 of the distinct parts underpinning our trader’s overall trading strategy. When deviating from the plan our trader has;
- failed in terms of his money management,
- failed in relation to his disciplined mindset,
- and allowed his method to be corrupted.
There is also one (often overlooked) aspect of trading that becomes dramatically skewed if traders violate their trading plan; the mathematical probabilities become so disrupted that attempting to rationalize our trades, by way of a forensic audit, is rendered pointless. This highlights point number one in our stress test for a potentially failing method;
Has our trader executed enough trades, using his current method, for the results to be regarded as statistically significant?
As part of our trader’s trading plan our trader must initially set out an account drawdown level; the percentage of loss on the account (or in monetary value) before our trader decides to stop trading and re-examines their whole approach to trading. If the drawdown is set at 10% account level then our trader needs to superimpose this drawdown on the amount of trades taken before the drawdown is experienced.
For example, if risking 0.5% of the account per trade then, in theory and simplifying for ease of discussion, our trader would need to experience a loss of 20 trades in succession to reach their drawdown. However, the essential issue is that the criteria laid down in the plan needs to be reached. If our trader experiences 6 losses in series, a total of 3% of the account balance and then panics, downs tools and looks for another strategy, then have they allowed enough trades to be executed through their method to make a fair evaluation of the overall trading strategy?
However, if our trader believes in extremely tight money management they could add an extra caveat into their trading plan; they can set the drawdown as previously mentioned at 10%, their risk per trade at 0.5% per trade, but critically add another layer of protection to their trading plan. They could add what could be termed a “series loss factor”; if the trading method loses perhaps six trades in series, then the method is judged to have failed as in terms of probability six failed swing/trend trades would be considered an outlier to ‘normal’ performance.
A reasonable example of this would be a trend/swing trader suffering six losses in series on the only security they trade, for example EUR/USD. If they were to lose six trend trades in series on EUR/USD and the losses suffered hits their stop loss on nearly every trade, then the trader would justifiably believe that their current method has failed.
Experienced trend traders would be looking for close on a 50:50 win loss ratio, with (hopefully) the R:R being twice the risk, perhaps a 150 pip gain for a 75 pip risk. If taking six losses based on the normal length a trend trade would last, let’s suggest a minimum of a week, then the trader will have reached the reasonable conclusion that, measured over a six week period, using six trades executed exactly to the plan, his current method has failed. There aren’t many experienced traders who would not agree with that conclusion, particularly when we take into consideration that much undermined and ignored ‘probability quotient’ into our trading strategy.
In many of our articles we stress patience and insist that traders have to execute their trading plan to the letter. It’s extremely important that, when entering what appears to be a drawdown, traders do not panic. Instead they should re-focus their energy on their trading plan and look for remedies for their current method.
Moreover, we constantly insist that traders should act as business owners; conducting forensic analysis on their current performance before deciding to change their method and replacing it with a new untried method. As can be clearly seen by the example that we’ve developed above, by taking a step back and applying more analysis, we can add layers of detail into our trading plan that can head off catastrophic losses before they arrive, whilst identifying poor trading methods before they damage our trading account so severely that recovering the losses becomes an incredibly difficult task.
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