How overtrading eats you alive

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Latest posts by Michael (see all)

overtrading kills your equity

Backtesting is valuable for system design, as well as getting emotionally prepared for what’s possible.

It shows you what your gains and losses would have been had you followed your rules over the previous time period that you’re testing. 

There are more things to measure besides gains, losses, and drawdowns. 

For all the trades that you make, you’ll have commissions and fees that you can calculate given what of your trades get filled. There is no cost for entering stop orders. 

If your backtest generated $60k for last year, but you didn’t consider the effect of commissions and fees, you might be surprised to find that you also generated $40k in commissions. Therefore, your net trading profits are $20k – a big difference than $60k. 

Worse, you don’t typically get filled at the price you entered in your order. Stop orders become market orders once elected. That means “you get in line” for the next fill based upon “Priority, precedence, and parity.”

The difference in the price that you entered in your order and the fill price is called “slippage” or “skid” and it comes as a cost to trading. You can add a number to your simulator to represent the slippage in your trading simulations that will represent the impact it will have on your trading and your P&L. This will give you a truer sense of what you’re endeavoring to do as a trader. 

Conclusion

Therefore, I’m concluding that when you overtrade, you’re getting the worst of it: you’re losing money, paying higher commissions, and losing money from slippage. That all comes out of your account and goes against your performance.

When try to overtrade your way out of a drawdown because you feel more frequent trading means more opportunity to win, you make a bad situation worse. 

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How to endure losses painlessly

It's a marathon, not a sprint

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Latest posts by Michael (see all)

consistency in trading

The duration of your drawdown is “how long” it takes you to get back to the previous high. It’s one thing to be down 10%, but how long will it take you to recover?

If your losses are “in model” there’s no reason to panic. You can get this information from backtesting your rules in a simulator. If you are trying to read charts, you’re out of luck because your activity is based upon guesswork. And worse, you’re looking at headlines for trade ideas which might lead to “acts of desperation” because your self esteem has taken a hit.

[In the course I teach, I show you actual trades and account statements where I’m in a 40% drawdown, stick to my systematic trading rules, and recover to the point where the account is up almost 300% over the next 9 months. The point is, I’ve been there, felt the feelings, and had to stay committed to my purpose.]

While you’re enduring a drawdown, your instincts might lead you to begin trading more frequently. 

Greater frequency of trades doest not equal greater opportunity. Most trades are suboptimal so I think you’ll do better in any case by trading less frequently.

Your instincts might also lead you to “investigate” a new trading methodology to “overlay” on your existing rules, such as option selling because it brings in “revenue.” You can lose your a** selling options. 

Behave consistently as you would when you’re up 20%. All you do is follow your rules. Take it one day at a time. All you can do is control your behavior. You’re powerless over what the markets do.

Two, if you’re down 20% and focusing your intention on getting 25% to get back to breakeven, you’re being myopic. Focus on getting the next 50% upside run. Intention equals results. Focus on new equity curve highs, not breakevens.

Meditate on how you feel when you have to be patient. You might feel anxious, depressed, angry, and frustrated to name a few. I don’t believe your can overtrade your way out of a drawdown. 

You may also consider trading a larger position on something that you are “sure of” because “…if it only goes up 10%, I’ll be back to even.” 

“To every thing there is a season, and a time to every purpose under the heaven” – Ecclesiastes 3:1, King James Bible

Your trading rules might be “out of season” with the market. If you’re a commodity trader, you know those markets are cyclical – so no surprise there. If you’re an equity trader, sectors rotate so your winners will ebb and flow in secular markets. 

You will go much further as a trader if you understand that losing money and drawdowns are not a reflection of your ability to create alpha as a trader. But how you handle losses and drawdowns emotionally and behaviorally will provide you and others insight on your managing larger sums of money. Investors and allocators need to know you can be trusted.  

Conclusion

Avoid adopting new systems, trading larger position sizes to “get back to even,” and increasing your trading frequency when in a drawdown. Your sense of persistence and determination will have a big impact on your equity curve and taking it to new highs. Consistency in your behavior reveals a lot about your character. Breaking the above rules suggests that you either lack confidence in what you’re doing or are much further from going pro than you think you are.

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Two techniques to master drawdowns

Focus on controlling your losses first

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Latest posts by Michael (see all)

dealing with drawdowns

If you want to be a professional trader, losses are part of the business. How a trader deals with losses, collectively called drawdowns, differentiate amateur from professional behavior.

If you’re down 20%, you need to do 25% to get back to even. This is important because you don’t participate in the upside, ie, absolute performance, until you actually make the client money on an “absolute” basis. If the market is down 10% and you’re only down 6%, you’ve outperformed the market on a “relative” basis. You need to make the client money in order to qualify for Incentive Fees.

Your sharing in the profits are called Incentive Fees or Profit Allocations and they are benchmarked against the initial account balance, aka, the “high water mark.” This “mark” will change over time as your equity curve hits new highs and the Incentive Fees you withdraw when you in fact are entitled to them.

Your ability as a trader/PM is going to be measured by performance or alpha, but also how little you lose. Risk adjusted returns therefore are your goal. If you can garner market-like returns but with only a fraction of the drawdown, you’ll be able to differentiate yourself from the competition.

[Remember, the riches go to the salespeople. You need to learn how to ask people for money. It won’t typically show up just because you have great risk adjusted returns. You need marketing and salespeople to ‘show and tell’ your performance.]

Shorter time frame trading does NOT give you more control over your losses or drawdowns. It just means that you’re likely to “die by 1,000 cuts” instead of taking a position and holding the risk overnight and over the weekend. Those are good risks to take. Selling or offsetting your trades because it’s the end of the day is known as “bad risk” – full of giant opportunity cost. In effect, you’re leaving money on the table by not taking winning trades home.

In order to minimize the impact of losses on your P&L and also on your emotional constitution, you can take a haircut on your equity when you’re in a drawdown. For example, if you get to 80% of a previous high water mark, you can trade based upon 60% of your remaining equity, and effectively trade 48% of your original capital. This helps you trade smaller when your system is not aligned with what the market is doing. Your bet sizes will be based upon a smaller capital base. 

Set a max drawdown limit for the day, week, and month to keep your losses in order. Examples can be “never lose more than 1.00% of your overall equity in one day,” or “stop trading at -9.50% for the month” thereby avoiding a double-digit down month.

This infers that if you’re at -9.50% on the 20th of the month, you stop trading until the start of the next calendar month. This may seem counter-emotional to you when I’ve told you to stick to your system, but you can benefit greatly as a professional trader/PM if you can say that “you’ve never had a down month of 10% or more.” This rule is a circuit breaker in your system.

Talk to prospective clients about how they deal with losses. If you show them that you have a superior methodology for dealing with losses than the other managers they’re dealing with, there is an opportunity for you to capture those assets under management. 

Conclusion

You need to have a plan to grow money (RoR), but also to deal with the magnitude and duration of your drawdowns AND the emotional effects that your losses will have on you. Don’t forget what Sun Tzu said in The Art of War: “Victorious warriors first win, then seek battle.”

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Forget returns – focus on behaving consistently

Risk adjusted returns put things in perspective

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Latest posts by Michael (see all)

trader performance

Gains look like gains only to the extent that you keep your losses small. 

Most traders trade too frequently, lose money, and quit the business in frustration because they are underfunded, focused on short-term time frames, and trade to large for their capital base.

You can gear your target RoR for a high number, like 100%, but you’ll also have to endure a drawdown of 40-60%. If you’re making 10-20% consistently and your drawdowns are no more than 50% of your RoR, you’re doing a great job.

What Traders Should Focus On

I’d focus on consistency in your approach and your discipline. That is what you bring to the table that amateurs cannot. If the average person could act consistently around managing risk, there’d be no need for portfolio managers. 

This podcast episode was inspired by a great email that I got about one particular trader’s performance and a few of his discussions with “prop trading desk managers” (read: brokerage).

There aren’t many prop trading firms out there. Most are brokerage masquerading as prop trading. True prop trading is a firm that will give you funds to manage WITHOUT your needing to deposit your own funds because you are talented. 

If you want to trade your own capital, wait 6-12 months and see if you’ve developed a sense of trust with the firm. Making a deposit to an account makes you a brokerage firm client, not a prop trader. 

Conclusion

Risk-adjusted returns are the key to getting an allocation. Sure you can get big returns, but at what risk to the operation? Anyone can roll the dice and hit it big once or twice, but that’s not how to build a business. Those type of results appear from random luck, not a bankable process that can be repeated like a robust trading system that can be deployed across many markets. 

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Why prediction is key to trader evolution

Model your risks and systematize them

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Latest posts by Michael (see all)

bold predictions don't pay

We make predictions all the time, so why not in your trading?

Professional traders will backtest and then add new elements or parameters to their existing system(s). 

Markets will evolve also, so you need to keep pace with evolving market environments. That means experimentation with something new. 

You can also test your hunches within the discretionary percentage of your trading. For example, some traders are 90% systematic and 10% discretionary.

Test your predictions and hunches in the 10% discretionary allocation. Just make sure to follow you risk controls, ie, max risk per trade and correlation studies before you put on the trade. 

I think prediction gets a bad rap because anyone who doesn’t have a system is effectively guessing at the market. That typically doesn’t work out that well for too long until your rules get systematized. For one, you need to have rigid risk management techniques in place. 

It’s likely that you will blow up if you put a large percentage of your capital on any one idea based upon a prediction or hunch. Risk 0.50% instead of 50%. Keep track of your guesses. There’s a chance that you might have great intuitive insight – especially after decades of trading – but don’t put your franchise at risk in doing so. Make sure you can come back and play tomorrow.

Conclusion

Your feelings aren’t facts and it’s better to gauge your reasoning with proper risk management. There will always be new ideas to trade, but if you roll the dice on one name based upon a prediction, with no training, you’re likely to get the worst of it.

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