Once we’ve traded on demo for a reasonable amount of time to finally test a strategy that we’re convinced has a positive expectancy and as such represents an ‘edge’, we should be adding to and perfecting our trading plan before finally moving up to trading real money. Within that trading plan we should make an allowance for how many trades we’re permitting ourselves to take in order to validate, or dismiss the strategy.
This ‘strategy validation count’ differs from the level of drawdown we’ll commit in the trading plan, but works in tandem with it. The reason we place a limit on the losing trades as opposed to a drawdown is that a losing trade limit can often forewarn the trader to the strategy’s failure ahead of reaching the drawdown limit. As such setting a trade limit drawdown can have the beneficial result of saving us traders a significant proportion of our account as the limit may be hit far ahead of reaching the financial, or percentage drawdown level we’ve set in the trading plan.
However, as with many issues relating to trading, we don’t have to set an arbitrary figure based on a hunch. As traders we can use all the familiar tools we’ve become accustomed to in order to set a trade drawdown level by adopting a scientific actuarial approach…
Within out trading plan we’ve set out our risk per trade, let’s presume we’ve settled on risking no more than 1% per trade. We’ve also set out that we’re only prepared to accept a drawdown of 15% of our account, and 15% appears to be the industry ‘norm’. Therefore (in theory) if we don’t micro adjust down the risk and keep the 1% loss always relating to the original account size, then we’re looking at 15 losing trades in series before our drawdown level is reached. But would we seriously allow 15 losing trades in series to occur and await the drawdown to be hit. Moreover, if we were dubious of our strategy and we enjoyed a 1:2 win loss rate would we allow approx. 23 trades to occur before committing our current street to the recycle bin?
Retail trader industry information confirms that the majority of part time retail traders are swing traders and the majority trade one security, EUR/USD. would we seriously allow circa 23 swing trades to occur with approx. 15 losers before stopping the strategy? And if those swing trades occurred over the normal distribution period then it could in theory take a year for us to make a decision as to whether or not our strategy has the edge we thought it did originally. Let’s be frank here, none of us can afford the time and cost of trading a poor strategy to its drawdown level if it’s going to take a year to analyse. So what’s the answer?
Instead of attaching a drawdown limit we could look for the most recent swing points to make our decision for us; the swing highs and the swing lows on our daily chart, to act as our arbiter were making a decision is concerned.
Let’s surmise that we, retrospectively, spot five swing points and those swing points have occurred over the past three months. If we’ve lost a series of five straight swing trades at those swing points then the answer surely becomes obvious as to how many trades we should allow before reconsidering our current strategy. The probability is that, over those past three months and during those five swing points, we’ve witnessed several changes in market sentiment and as a consequence can see clearly where our trades have failed and more importantly why. Therefore our decision to cut our losses on our strategy could save us circa 10% of our account; instead of losing 15% we’re now looking at a 5% loss and that’s assuming a worst case scenario that our losses all come in series and to the full 1% risk loss per trade. Oh and before we finish there’s an irony and unintended consequence in our detailed analysis; perhaps the 15% drawdown that so many, including analysts, suggest is the maximum we should contemplate is way too high, does a 5% drawdown now seem far more reasonable and realistic for swing/trend traders?
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