How a simple ‘circuit-breaker’ can save your trading bank

Sometimes you can find yourself simply out of step with the market.

It could be your strategy just isn’t suited to current conditions (even though you are executing with iron-willed discipline).

Or it could be caused by something more personal: you might be a bit off-colour health wise, or you might have other demanding things going on in your life.

And it can all have a draining effect on your trading powers. But you can only do something about it once you’ve recognised it.

So how do you know when these conditions are in force?

Easy, you feel it in the pocket!

These are the times when you suffer more losing trades than you’d otherwise expect. When you sit scratching your head, asking why your otherwise solid campaign seems to have gone a bit wonky, and wondering what you should do about it.

It’s an important situation to address. We spend a lot of time looking at ways to make money from trading, but priority number one should always be to protect what you already have!

So let’s go back to basics for a minute… let me tell you why I think of trading as a two-phase process:

Phase 1 = Survive

Phase 2 = Prosper

Your first job as a trader is to survive!

Now Phase 1 – surviving – is usually the ‘beginner’s’ stage.

So this could be a complete trading newbie coming to the markets for the first time. He’ll be learning the ropes and focussing on staying in the game long enough to develop the skills that’ll let him transition to phase 2 (prospering).

Or it could be an experienced trader trying a new strategy or approach for the first time…

Even though this trader has a lot of previous experience he still goes through a ‘mini’ beginner’s stage while he learns a new technique. The methods are all a bit unfamiliar and he expects mistakes to happen while he goes through the learning curve, so he treads carefully. He conducts his business in survival mode (low stakes, double-checks all his trading decisions before pulling the trigger) until he’s ready to scale things up.

Experience and confidence then allow you to prosper

In both cases phase 2 – prospering – comes with confidence and experience. Once you’re happy with your ability to trade in a way that doesn’t put your bank at risk, and you’ve seen small profits you can then move your focus to maximising returns.

But the prospering phase doesn’t always follow neatly on after the survival phase. They are not mutually exclusive.

Just because you’ve gone though the beginner’s learning curve it doesn’t mean your approach to the markets will perform in a similar way for evermore. You must always have one eye on the downside.

And when it looks like things are going a bit wobbly, when market conditions seem odd, switch back to ‘survival mode’. Don’t risk blowing up your hard won profits out of sheer stubbornness!

So let’s have a look at some ways you might manage your trading activities with this in mind.

Position traders and swing traders might employ a monthly drawdown ‘circuit breaker’

Let’s say you’re an end-of-day trader. You look for two or three opportunities per week and you risk 2% of your account on each trade. How might you limit your activities so you never risk causing fatal damage to your funds? What’s going to pull you out of dangerous market conditions or protect you from challenges to trading performance that come from your personal life?

One way you might do it is use a simple ‘circuit breaker’. It means you’d stop trading for the month once a certain level of drawdown had been reached.

So if you started the month with £1000 in your trading bank and you’re risking £20 (2%) on each trade you might pull the plug if your account balance dropped to £900. That would be a 10% drawdown.

This would allow for five consecutive losing trades. It would pull you out of unfavourable market conditions, and it would also protect you from too much self-inflicted damage if your decision-making processes were affected by other things.

(Plus, it would have the added bonus of keeping you on the straight and narrow when it comes to discipline and sticking to your trading rules!)

But what would you do once the circuit breaker kicked in?

You’d continue to paper trade your strategy. You’d want to monitor the performance of your approach but wait to see a return to form before going live again. And you’d need to wait until the next valid period begun before placing trades with real money.

You could manage this on a calendar-month basis, or on a rolling 30-day period, i.e. you’d have to wait 30 days before live-trading again (or wait 14 days, 21 days… whatever you feel would best-fit your level of trading activity).

Just make sure you set up the rules before you need them! Don’t risk waiting until you’re in the middle of a sticky patch before deciding how you’ll handle it.

Day traders might use a daily threshold limit

Now let’s look at things for a short-term trader…

Let’s say you’re an active daytrader. You typically trade 5-10 times a day and you risk 1% of your account on each trade. How might you put a self-enforced limit on poor performance?

Well, because of the shorter timeframes involved and the added element of time-pressure on your decision-making, it’s important to note there’s more scope for things to go ‘wrong’ faster here. If you or your strategy is off the boil, you’d want something to get you out quickly, before too much damage is done.

If you were trading for a firm, you’d have a risk manager breathing down your neck. He’d pull the plug on your trades once a certain amount of loss had been realised. Kind of like the cartoon hooked-stick yanking you off stage by the neck!

But as home traders we don’t have that luxury. So again, we need make sure we have some rules set up in advance, ones we can’t easily override if we get swept up by emotion in the heat of a frantic session!

A preset number of consecutive losing trades might be the answer for you – I will stop trading if I take three losing trades one after the other.

Or you might prefer a monetary based drawdown figure if it’s normal for you to take many small losses on the day. You might be on hunt for just one or two trades that deliver huge returns, so in that case it might be a case of I will stop trading if I suffer a £200 drawdown.

One good way to enforce this might be to hold in your trading account only enough funds to cover the margin requirement for your normal trade, plus the amount of drawdown you are willing to accept.

If that loss were suffered you’d then have to physically transfer more funds before trading again.

This could provide a valuable ‘cooling-off period’ that might help prevent you ploughing on with more losing trades if you’re still working on the self-discipline side of things.

Anyway, that’s just a couple of ideas for how you might build a ‘survival mode’ into your campaigns. If you do a little bit of planning I’m sure you can come up with something creative and effective that will suit you and your trading outlook perfectly!

Be Prepared: Market Moving Data Coming This Week (London Time)

Wednesday 13th April
13:30    USD    Retail Sales
13:30    USD    PPI
15:00    CAD    Monetary Policy Report & Interest Rate Decision
16:15    CAD    BoC Governor (Poloz) speaks

Thursday 14th April
02:30    AUD    Employment change
10:00    EUR    CPI
12:00    GBP    Interest Rate Decision
13:30    USD    CPI

Friday 15th April
03:00    CNY    GDP & Industrial Production

Monday 18th April
– no big reports

Tuesday 19th April
10:00    EUR    German ZEW Economic Sentiment
13:30    USD    Building Permits

Not too much on the table this week in terms of quantity of reports, but do keep an eye out for those interest rate decisions!

Until next time…