Excellent Question From a Reader

A reader asks:

"Does your in-sample testing account for almost a 50% drawdown? If not at what point do you say the strategy is not working any longer?

Thank you for your blog and your transparency. It's encouraging."


Thanks for the question.  The transparency unfortunately sometimes makes me look like a fool.  Seriously, what kind of "professional" trader has a 49% drawdown, and a 41% drawdown?  Having to post my equity graph the past week has been awful - really, it is 10 times worse than the $5,000 I've lost during the drawdown.  It is an ego deflater (which is probably a good thing, in the long run - I know arrogant traders, and I know rich traders, but I do not know any rich, arrogant traders.).  


Many people would have quit after that first big drawdown.  Emotionally, I can relate.  BUT, if the numbers predict it could reasonable happen, then it doesn't make sense to quit.  That is the case here.


Let's look at the system I am trading.  I started with only $10,000, which I knew would likely put me in a precarious drawdown situation, sooner or later.  But I was going for absolute percentage return, so it makes sense to start with the least amount of capital you can.


There is an important lesson here, and it all goes back to what your goals and objectives are.  My goal was percentage return.  If the goal was risk adjusted return, I would have done things differently.  Started with more money (probably not a help), or likely traded a whole different system (one that had more limited upside, but less drawdown potential).  


Anyhow, I ran the contest system through my Monte Carlo spreadsheet (free, on my website), and I determined that within a year, there was a 65% chance that I would have a maximum drawdown of at least 50%.  In other words, there was a very good chance of a 50%+ drawdown.  The graph is below.


The flip side, is how much gain could I get out of this system?  The same analysis shows I have a 60% chance of at least tripling my money.  And that assumes that I keep trading 1 lots through the year.  I'd probably increase size, so I might do even better.


Basically, I decided that these were odds I could live with.  Not everyone can.  And I certainly would not have these types of odds for my other accounts.


For this system, since it is a contest, I am going to quit only if I cannot place a trade.  Again, in my "normal" accounts I'd never do that, and I don't recommend you do this.  But this approach fits my objectives, which is the key.


If this analysis in confusing, please feel free to ask questions.  I want to make sure readers understand.