So you want to change your trading strategy, where do you begin and how dramatic should the changes actually be?
We’ve given our current strategy enough time to either work (or fail), so how do we now go about making a clean break and starting with a fresh new ‘shiny’ strategy? And will this gleaming new strategy be any better than the previous one, or are we looking for a change for the sake of change when our current strategy might only need the smallest of tweaks?
The most important issue, before we actually condemn our trading strategy to the virtual trading recycling bin, is to (without any shadow of a doubt) be completely sure that the strategy we’d originally developed, placed faith in and selected isn’t actually working. And a quick reference to our trading plan should confirm this. By simply overlapping our trade results with our trading plan we should be able reveal if the strategy has in fact met our expectations, or failed.
In our plan we’ll have laid out certain basic trading rules such as; the drawdown level we deem to be acceptable, the likely volume of trades to be taken on a daily basis and (based on our original projections) how long our testing of the current strategy will take in order to establish its worth. And that last statement is absolutely crucial as any of the overall trading methods and strategies we select should always be considered to be in ‘test mode’ until we’re completely committed and convinced that our strategy is in fact generating income.
If we’re a swing trader and we’d set a drawdown of five percent, whilst risking 0.5% per trade, then in theory we’d need to suffer 10 losses in series to have blown through our drawdown level. More likely, if we’ve experienced a (roughly) fifty/fifty per cent win loss ratio, then we’ll have taken 20 trades to have hit the drawdown level, that’s assuming our poor, condemnable strategy has losses twice as big as our winners. If we were using trailing stops perhaps the total would have been thirty given that our trailing stops could have ensured that our losses on many trades fell short of the full amount risked of 0.5% per trade.
But assuming that we did lose to the full extent of 0.5% and the average time we spent in each swing trade (successful or unsuccessful) was five trading days then we should have (in theory) tested our overall strategy over twenty trades and a one hundred day period, or roughly three months. During which time we’d have hopefully experienced many of the usual trading phenomena; such as violent breakouts to the upside or downside based on fundamental policy shifts by, for example, central bank planners.
It’s very important that we use the kind of failure template we’ve outlined here to ensure that we’re not closing our strategy too early. But if we have subjected our recent strategy to the rigorous post-mortem analysis laid out earlier and as a consequence we are convinced that it’s now time to change and if our losses are twice as big as our winners, then how we select another trading strategy may be more difficult than we imagine…
Evolution not revolution
The knee jerk reaction we experience, when a strategy we’ve placed faith in no longer works, is to dramatically end it without engaging in any of the due diligence measures we mentioned earlier. This can be a mistake as if the strategy has failed around the parameters we’ve mentioned earlier, then to call it failure would be a mistake. If the strategy has enjoyed a close on 50/50 win loss ratio, rather than the 60/40 we’d hoped for, then to condemn the strategy as a failure could be extremely premature despite the losses being twice the value of the winners. And the really good news is that (admittedly) we’ve had a bit of a disaster, but over a three month period we’ve only lost 5% which is easy to recover from. We may be best analysing the strategy performance in more detail to establish if a tweaking of the current strategy may be more appropriate. But after doing so if we still can’t rationalise the strategy with our trading ambitions and as a consequence we’re determined to develop another strategy, then we’re ready to begin the process to decide which and how we go about selecting another strategy. The parameters surrounding our selection process will form part two of our two part article available to read tomorrow.