In my previous column, I ended with the premise that even though your system may have a positive edge, BUT HAVE YOU FACTORED IN THESE CRITICAL AREAS?
System wins rate or winning trades percent, which is arrived by simply dividing the winning trades by total number of trades. Usually, the bias among majority traders is towards having a high win rate system as it easier on the ego and the psyche to have a relatively smaller number of losing trades. Most professional traders that I have met have a win rate of less than 35 per cent.
Does this surprise you? This means, simply, that they have more losing trades than winning trades. This might make you think how do they end up being profitable? We all have heard the old adage, cut your losses and let your winners run.
Professional traders always let their winning trades run and cut their losses short hence their average winners are always much larger than their average losers and this is where they make the big returns, unlike amateurs who are more focused on being right.
Due to this, one common mistake they do is being hopeful when trades go wrong and fearful when it goes right. One must take heed from the legendary Jesse Livermore who said one must be fearful when wrong and hopeful/greedy when right.
You have to realise that no one knows the outcome of a trade whether it would be a winner or loser. You also have to take every trade as there are chances that the next trade could be an outlier trade. If somebody claims to know in advance which is a winning trade, then they would have bet their entire stake on this trade and would have become a millionaire.
On the other hand, systems with high win percentages don’t guarantee assured returns. At times they may end up with larger losses and smaller wins.
Greatest number of consecutive losing trades
Let’s say the system results show that at one point of time the system went through 12 losing trades, would you be able to handle 12 losing trades in a row? I can tell you from my decades of experience that over 90 per cent of traders (and this is a conservative estimate) wouldn’t be able to handle it. In fact, after four to five losing trades in a row they will stop using the system and would hop on to some other system. Even a system with a 50 per cent win rate can have more than ten plus losing trades in a row.
There may also be a case where the biggest winner makes up for more than 35 per cent of the total profits accrued, which simply reflects that it’s too skewed, ideally if the winners are not too skewed with minor deviation works well.
In case of the biggest winner being 35 per cent plus what could possibly work against you is this: Supposing you have five losing trades in a row and you are too scared to pull the trigger. Because of this reluctance, you could miss out on this big winner which would result in your profits being lowered by that percentage. Or, there could be certain unavoidable or situations you haven’t factored in like your internet is down, or you are stuck in a meeting which may result in missing out on the trade.
Even though your back tests results may show a positive expectancy, but what if the drawdown is upwards of 20 per cent? What if the drawdown lasted for over six months? Would you be able to handle it?
Also, you need to check the time period required for the draw up basically time taken to recover from the drawdown which may run into several weeks to months in case of trend following system.
Another factor that needs to be considered is the time taken between two equity peaks, ideally shorter the better. Which means that if you have a faster system something like an intraday system or BTST overnight system such systems generate much higher number of trade signals, unlike a long term trend following system which may have about 50 odd trades in a year. In such a case, the period of draw up would be relatively higher.
Misconceptions regarding system trading
A majority of traders think that system trading is the ultimate grail in trading as it spews money by the minute, Sadly, it is not. In simpler terms, system trading is where you have predefined the entry rules, exit rules, trailing stop loss and risk. Basically, system trading takes out the discretionary element and also avoids impulse trading.
The second misconception is that system trading takes the emotion out of a trade. This is just a myth. Nobody likes to lose. Because markets are random in nature, the outcome of a trade is unknown. Also, the probability of losing is 50 per cent, so the moment your money is on the line, emotion is bound to be there.
Thirdly, let’s say your back test results for the first year showed that you had a six-month winning streak where there were fewer losing trades and more winning trades. Do not be under the false illusion that when you start trading the system live you are going to encounter the same winning streak.
If it was so then everyone would only take the winning trade as per historical back test data and would skip the losing trade. At this rate, everyone would be a winner and there would be no losers. Wish it was that simple.
It’s quite likely that once you start trading the back tested system live you could start off on the worst note. This means if the historical data showed twelve consecutive losing trades, then it’s quite likely you may start off with may be twelve losing trades or more.
The main objective of back testing apart from having a positive edge is the pain level that the system went through to end up with the gain. The majority get swayed by the returns the system has made and forget the painful journey it endured.
One thing you have to get straight is that no system in the world will only spew winning trades; every system goes through a losing streak which may last for days, weeks, months and even years at times. And you have to endure that pain.
At the end of the day you have to question yourself is the pain worth the gains? And will your personality be able to handle the pain, forget trying to tail coat another system in the long run you will end up losing money whereas the person from whom you copied he system will end up profitable due to personality mismatch.
Lastly, even though the system has made money but has it outperformed Nifty returns during the same period?
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Kirit Manral is a professional trader, and has been running a mentorship program in trading since 2019, with mentees from around the globe. He can be found on Twitter at @KiritManral