Ever feel the market somehow knows what you’re up to?
You buy on a breakout… only to see price immediately reverse.
You move your stop loss order to breakeven… only for the market to stop you out, swivel around, and then continue back in the ‘right’ direction.
And perhaps most painfully of all, you call a temporary halt on trading your system as it goes through a period of drawdown. It then enters a glorious turbo-charged streak of winning trades (with you sat open-mouthed on the sidelines).
The problem is, we’re almost hard-wired to act against our own best interests in the financial markets. What serves as an act of self preservation in the outside world can have the very opposite effect in the markets and vice versa.
Why our herd instincts act against us
It’s because generally, most of us have a similar tolerance to physical and emotional pain. It binds us together as a herd.
For example, the majority of buyers in the market at any one time will all be eyeing the same price area to use as their stop loss. It might be the area immediately below a recent low which does make logical sense. But the big players (the smart money) know exactly where those stops are going to be and they’ll be gunning for them.
They know the psychological makeup of the majority of traders and will be trying to steal their lunch. It’s why you see statistics like 90% of newbie traders not lasting more than a couple of months. If they don’t learn a few survival tricks, quickly, they get eaten alive.
And listen to this…
There was a trader at the Chicago Mercantile Exchange – a lady trading Eurodollar futures – who single-handedly accounted for the bulk of the volume in that pit. If she took a day off many of the other traders did too. It wasn’t worth them turning up as the market didn’t tend to move.
She regularly banked double-digit million dollar annual profits and put her success solely down to the ability to withstand more pain than anyone else.
While others were bailing out, she was working her losing position… eventually turning their pain into her profits. No mean feat when she stood to lose a seven-figure sum if she got it wrong that day.
Now that’s all well and good if you REALLY know what you’re doing. But you can’t go trading recklessly and then try and pass it off as some kind of macho sweat-test.
And I don’t want to get too closely focused on individual trades here. Like I mentioned earlier, I think the bigger issue for most experienced traders is how to handle a period of drawdown…
On one hand you need the guts to ride out your losses – the ability to do so is a key part of trading success. On the other hand, you don’t want to throw good money after bad. If your system is off the boil you don’t want to risk blowing up your whole account.
Hmm, a dilemma. There’s no magic-bullet answer but I do have three ideas for you to consider…
The first is a textbook approach to risk management. The second method is a bit unorthodox – it applies some technical analysis to the chart of your account equity curve. But the last is truly radical: food for thought, but proceed with caution!
Here they are…
Three ways to stay out of trouble if your system goes into meltdown
1) Stop trading after an equity drawdown of 30%. This is the one you’ll see in all the trading books
You know the kind of thing – if you suffer a drawdown of, say, 30% stop trading. You’d need to see account growth of 43% just to get back to square one. Let the drawdown run to 50% and you’d need 100% returns just to square yourself up.
And that all makes good sense but at which point do you start taking trades again when the system bucks itself up?
You could paper trade the system after the 30% drawdown and wait until paper returns are back up to recent highs. You could then go live again but you’d have missed that period of recovery on your live account.
That’s why I think method number 2 could offer you a bit more helpful guidance…
2) Apply a moving average to your equity curve
Make a line chart of your account equity curve in a spreadsheet and retro-fit a moving average to it.
Assuming an upward sloping equity curve (I hope!) you want the moving average to contain 85-90% of the historical price action. You then simply use the moving average line as a filter to keep you out of sustained periods of drawdown…
Current equity drops below the MA – you stop taking live trades.
Keep track of the system’s results with paper trades of course. That way once the equity curve rises majestically back above the MA, you start firing live bullets again.
It’s not perfect of course – you can still miss the odd good trade on a little blip below the MA, but it will certainly keep your powder dry in the event of a big system-wide drawdown.
Here’s how it might look on your equity curve chart:
So here we have your equity curve (blue line) and its 14 period moving average which traces the up-curve.
After 57 trades, the system takes a blip and equity drops below the MA – that’s your cue to be cautious and stop placing live trades.
Once the paper-traded results move back above the MA you could take confidence that ‘normal’ conditions have returned for this system and get back to business with your live trades.
And if the equity curve stays on a prolonged downward slope, you might consider this…
3) Trade the system signals the wrong way around. Buy instead of Sell and Sell instead of buying.
This one started off a bit tongue in cheek, me playing devil’s advocate. But if your system has gone into meltdown and is producing sustained losing trades why not turn it around and start taking the OPPOSITE position. Buy instead of sell and vice-versa. Your target goes where your stop loss would normally be.
It won’t work with every system of course, but it can certainly help you see things in a different light.
At one time, there was a story doing the rounds about the son of a wealthy speculator who was very bad with his timing. He had the Midas touch in reverse – all his trades went wrong.
Father eventually instructed the family’s broker to intercept his son’s orders and start placing them in the market the opposite way round. Profits started pouring in, but the son – non the wiser – couldn’t understand why everyone was so happy about his ‘losing’ trades!
Is it a true story? I don’t know about that, but just think how a bit of creative thinking along those lines could preserve your account.
It might even give you your next big lucrative trading idea!
Be Prepared: Market Moving Data Coming This Week (London Time – BST)
Wednesday 21st May:
09:30 GBP MPC Meeting minutes
09:30 GBP Retail Sales
16:30 USD Fed Chair Yellen Speaks
19:00 USD FOMC Meeting Minutes
Thursday 22nd May:
08:30 EUR German Manufacturing PMI
09:30 GBP Gross Domestic Product
15:00 USD Existing home sales
Friday 23rd May:
07:00 EUR German GDP
09:00 EUR German IFO Business Climate Index
15:00 USD New Home Sales
Monday 26th May:
All day USD Memorial Day Holiday
All day GBP Late May Bank Holiday
Tuesday 27th May:
13:30 USD Core Durable Goods
15:00 USD CB Consumer Confidence
So remember, next time you go through a bare patch with your system don’t panic. Think how you can manage your risk but be ready to jump back on board once the profits are flowing again.
As always, shoot me an email with any questions or comments and I’ll catch up with you next week. Until then…