The Fine Line between Drawdowns and Risk of Ruin
For the vast majority of traders….a drawdown is just a short term symptom of a slightly longer term problem being total risk of ruin. Drawdowns are only useful for those that can survive them and to achieve this over any extended duration you must have an edge.
For those traders that have never tested if their strategy is robust and has legs over a broad range of differing market conditions (which is probably most retail traders), then you need to have a plan in place to determine when too much is enough.
The critical things you need to know to evaluate your systems robustness are as follows.
- The risk of ruin. This needs to be 0 to ensure long-time survival in this game. More about this here (bettersystemtrader.com/riskofruin/).
- Your long term expectancy. More about this here. (www.vantharp.com/tharp-concepts/expectancy.asp)
- Your trade frequency (or opportunity). This is required with your expectancy to calculate your anticipated return stream and hence your level of capital required.
In determining your maximum drawdown tolerance which is used in determining your risk of ruin, you need to assess what level of capital loss you are prepared to endure before you call it a day with your strategy. Obviously this level increases as your capital stake decreases which is a natural symptom associated with your psychological risk tolerance. Having more capital at stake tends to make traders much more risk averse.
Once these calculations are performed (which is only possible with a very large data set…and hence the need for extensive backtesting), you can then set your leverage with position sizing to meet your risk tolerance levels provided of course that the future endures a similar set of market conditions to the past. Obviously the more comprehensive the sample size (from your backtest), the greater ability of your backtest to capture a broader range of market conditions.
When you do this exercise you quickly realise how most retail traders and their risk appetites will not avoid risk of ruin. The probabilities virtually guarantee it. This process ensures that your risk appetite is balanced against more realistic return expectations. Once this is achieved you can then assess in a far more rigorous manner if your strategy has an edge or not. Most new entrants to the trading game think their good performance returns over a small sample size demonstrate a statistical edge….. only to find out that they were trading a strategy that was optimized for a particular market regime.
An edge is a long term statistic that many simply do not understand. The temptation is to equate a performance track record of say 1-3 years as demonstrating an edge….whereas the reality is that particular market conditions such as mean reverting environments and momentum periods can last anywhere between 5-10 years or longer. The only way to increase your confidence in displaying an edge is through a long term back-test across a broad array of different market conditions. It is not the extent of sample size that is important which most people think….though it helps. It is actually the extent and duration of variation of historic market conditions that is essential in determining whether or not your strategy has an edge or not.
There is no guarantee of an edge. There is just a confidence interval you can attach to it…….. but to have higher confidence in your ability to survive the markets an understanding of which market conditions your strategy performs in…. as well as which market conditions your strategy under-performs in….. is an essential requirement for anyone who wants to survive in this game a long time.
There are very few truly unsuccessful strategies. In fact these are as rare as successful strategies. For a strategy to be truly unsuccessful it has to under-perform the frictional costs of trading such as spread, SWAP and slippage. If you reversed a truly unsuccessful strategy, then by definition you would have a profitable one….which is a rare event. The vast majority of strategies that retail traders deploy are therefore simply trading randomness. Many confuse a sequence of random beneficial events as displaying an edge……but there will always be successful coin tossers simply given the nature of the random walk. Most simply do not understand what is required to allow for the Law of Large numbers to bias the result.
People often say that trend traders endure high drawdowns. Well the reality is that there are very few techniques apart from trend trading that can survive over an array of different market regimes. Despite the appealing linear equity curves of negatively skewed systems, these curves are simply a short term extract of an enduring favorable market condition. When conditions change….as they do from time to time….. those linear curves evaporate with typical account blow ups. To see the full picture you need to access the unrealised equity curves or more importantly the entire equity curve over multiple market conditions. Given that negatively skewed systems inevitably end in complete risk of ruin, you can rarely find any long term examples of these methods. These short term appealing techniques that are so attractive to the retail trader have very finite life times. Their worst drawdown actually tends to be their risk of ruin.
So having a volatile drawdown profile over a broad array of multiple market conditions is not something to fear. It is actually a tell-tale sign that risk is being managed prudently and not hidden or transferred. The volatile equity curve of the long standing diversified systematic trend followers is a signature of full risk release. Alternatively the linear equity curve of a mean reverting system with no stop condition, a Ponzi scheme, a Martingale system or grid trading system is a sure sign that risk is still present in the system, but simply temporarily suppressed like a pressure cooker.
To have a drawdown of 55% to 60% over a 20 year trading period is a simple fact of life for trend traders and something to embrace rather than fear. Most other trading techniques offering negative skew would not survive beyond say a 3 year time horizon without the need for significant revision.
Of course we are all attracted to the ‘promise of riches’….so it easy to be conned into the lure of a system with a high win rate….however in this game it pays to establish realistic expectations from the outset. To severely shortcut your journey towards proficiency in this game you just need to ask the following questions and follow this process which has frequent repeating loops.
1. Firstly ask the question…..Who has a demonstrated verifiable long term audited track record and what are the performance results telling you? You will not be able to verify anything put in front of you on trading forums, Youtube teasers or dodgy marketing bulletins and it is prudent to remain skeptical. The places I advise those interested to look are the audited performance returns of the Fund managers who under regulation are required to release their performance results.
Remember as speculators, the best places to find ideas as traders are not the banks but the FM’s who have a similar investment philosophy. Not many guys from the banking institutions who were simply operating under the mandate of their employer in acquiring or disposing of positions have what it takes to be a retail trader in delivering an edge…despite the ego’s that might declare otherwise. The most closely aligned segment of the professional industry to us retail traders are the Fund Managers running investment portfolio’s for their clients. This is where you need to look for ideas. Here is a fruitful source.
2. Once you become familiar with these performance returns and their associated drawdowns/volatility of returns over the long term, you then need to ask yourself the question….given the skills of these managers and their access to proprietary research and resources, what are the likely level of returns and drawdown etc I can expect as a retail trader following the same generic principles as these guys? What this question will do is hopefully set realistic expectations in regards to performance expectations recognizing of course that it is very unlikely that you will outperform these guys….excluding luck of course. It will also give you an appreciation of the variation of returns attributed to varying market conditions and to the nature of the strategies deployed which is an extremely important facet to understand if you want to be trading for the long haul.
3. Now that realism has had the chance to dilute hopeful expectations you are then ready for the next research phase of the exercise before even considering trading live. What you need to do is to then undertake as much research as you can to understand the principles and practices of the professional fund managers who post these verifiable audited returns. What this exercise will do is hopefully lead you in an objective manner towards the more successful techniques that have a proven track record in delivering an edge above and beyond simple market returns. This process will allow you to sort the chaff out from the wheat and answer questions regarding what are the most successful strategies that are deployed by these fund managers. Have a look at those guys trading using discretionary Technical Analysis, Pattern Recognition, Data Mining, Fundamental Analysis, or systematic Trend Following/Momentum approaches etc. and then you be the judge after you have had a chance to digest what the performance returns of the variants are. This can save you years of grief following a useless cause. During this phase of research you need to understand how these guys work. There are a plethora of excellent books and free podcasts that will help you in your quest from the professionals in the industry.
4. Now that all the hard yards are done, it is then likely that more hard yards are to follow as you need to develop analytical tools and perhaps learn some programming to be able to emulate these guys and your preferred approach…..but it is well worth the effort.
5. Then the next step is to develop the strategies required for you to be able to navigate whatever the market throws at you and be in a position to adapt to changing market conditions. Clues to the strategies to deploy will come from your research phase.
6. Having developed your range of trading strategies that address a myriad of different market regimes, you then need to comprehensively test them to provide a blueprint to guide your future trading activities. This process will take some time where you start to appreciate the market for what it is.
7. ….and then and only then are you ready to dip your toes into the market with a very small account that you are prepared to lose to live trade and test your strategies. This is where you find out about the psychological side of trading….and this needs to be an extended process where you have the ups and the downs and understand how your psyche fares under these conditions and what issues arise that you need to be able to control because of them.
8…….and once you are happy with all that, you have then earned your yellow belt and are ready to trade for real….and then the game begins in earnest and you continuously strive to improve yourself.
9….but at all times during this process of personal development a key requirement to keep in the back of your mind is to stay humble and never conclude that someone is right or wrong. Just test it yourself to be able to form your own opinion. Become a scientist and test all your assumptions. This will build your skills of self-reliance which is essential in this game and prevent you from becoming just another victim that can be exploited by the sharks in this market.
Easy right…..don’t just stand there….time is running out……..so get crackin’
Trade well and prosper