Should the market turn against you, it is important that you design a system that will produce as much loss as you are prepared to take. This loss, known as drawdown, is the maximum amount by which your trading float will temporarily drop at anytime. Doing this in advance, will help you avoid nasty surprises in the future. This gives you the confidence to continue trading when the good times start once more.
It is very unlikely that you will stop trading if your system is trading profitably. However, if you are in a trading year that takes too big a loss, you are likely to stop trading, even if your system has been tested and shown to make a profit over a longer time period. Therefore, design a system based on the risk you are prepared to take which includes a budget for your drawdown.
So how does one pick the best formula for your drawdown time? I will rephrase this question. How many losses in a row should you allow for?
First, I will use the simple example of tossing a coin. If I tossed a coin and it landed "Heads Up" 10 times in a row, are you surprised? However, if I tossed the coin 800 times, your outlook on the results are different.
Trading uses the same scenario. When testing your trading system over many years, you will find a run of 10 losers or 10 winners in a row. Mathematics provides some answers to the likelihood of this happening.
See the examples given in the table below:
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Probability of Losses in a Row
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System Win/Loss Ratio 60:40 50:50 40:60
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5 losses in a row 1% 3% 8%
6 losses in a row 0.4% 2% 5%
7 losses in a row 0.2% 1% 3%
8 losses in a row 0.1% 0.4% 2%
9 losses in a row 0.03% 0.2% 1%
10 losses in a row 0.01% 0.1% 0.6%
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A typical trend following a system has a 50:50 win: loss ratio. That is, half of the trades are winners and half losers. This is not a problem, because winning trades will make a larger profit than losing trades will make a loss.
A 50:50 system has a 1% chance of seeing seven losses in a row. Therefore, most trend following systems should budget between five and nine losses in a row. The good news is that there is the same chance of getting between five and nine winners in a row!
I hope you see the importance of making these decisions before you begin trading. Making the proper decisions before you start is what successful trading is all about.
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