![]() ![]() Use of market orders leading to high levels of slippage and reduced profits.There are literally dozens of common trading mistakes you could be making, but some of the most common which cause unexpected drawdowns include: Often times when traders have larger than expected drawdowns the cause of the drawdown is actually mistakes made in executing the signals from the trading system. The first check you should do is on your execution of the system. The real investigative work starts when the current drawdown is larger than the historically backtest showed when you designed the system. The key to successful systematic trading is not having one perfect trading system, it is having a diversified portfolio of good trading systems that complement each other. The great thing about this scenario is that it creates spare capital which you can then allocate to a different trading system that will provide you with additional diversification. Allocating less capital to your system will reduce the potential dollar drawdown in your account so you can keep trading the system comfortably. This is because the system is not broken, it just has a bigger dollar drawdown than you are comfortable with. If you are uncomfortable with the real time drawdown in your account but your backtest shows that the current drawdowns are within historically normal bounds then the best course of action is to reduce the amount of capital allocated to the system. When trading systematically it is critical to monitor the system’s stability and drawdown against the system’s historical performance rather than just our own level of comfort.Ĭlearly if you are comfortable with your system’s performance there is no further to do so I will skip over this scenario. If your system’s maximum historical drawdown during backtesting was 15% and you are now trading live and suffering a 25% drawdown then something could be seriously wrong. Similarly if you have a maximum drawdown tolerance of 40% and your system is in a 25% drawdown, it doesn’t mean your system isn’t in trouble. This is why it is so important for your trading system to fit you! So trade that system with a lower capital allocation and add another (different) system to your account for the rest of your capital. However there is no reason not to trade the system – you just need to allocate a smaller percentage of your account to that system so that the drawdown at your account level is within your tolerance. If you allocate all your capital to a trading system that has a larger drawdown than you are comfortable with then you will end up with an uncomfortable drawdown from what could be a perfectly good system. This doesn’t mean your system is broken, it just means you have a capital allocation problem or the system doesn’t fit you. If you have a drawdown tolerance of 30% but your system has a maximum historical drawdown of 40%, then you have a problem because eventually you will exceed your maximum comfortable drawdown. The first gives you your goal for your portfolio and the second gives you a benchmark to monitor your trading system against for stability. In order to be a successful systematic trader you need to know the answer to both of these questions. What is my trading system’s maximum expected drawdown?.When thinking about your drawdown when you are using a trading system, you need to ask two questions: When trading with a trading system the approach is a little different… and in fact the questions are different too. You must take action, but the ideal approach is quite different. This could be devastating to your account.įor traders using a trading system (as opposed to discretionary technical analysis) the answer to the question is quite different – taking a break from your trading system is not a good idea. If you don’t have a circuit breaker like this then you could end up digging yourself into a huge hole you can’t get out of. Taking a break from trading if you exceed your maximum tolerable drawdown is good advice when trading with a discretionary technical analysis approach because you need a circuit breaker to tell you when you are out of sync with the markets. It is good advice if you are trading with a discretionary technical analysis approach. I remember learning this concept and even building it into my trading plan early on in my trading career. There is a common piece of conventional trading wisdom that says that when you hit your maximum tolerable drawdown your should take a break from trading and reassess. One of my students recently asked me “What happens/what do you do, when you hit your max draw-down? Do you stop trading and take a break? Keep going?” What to do when your trading system hits your maximum historical drawdown?
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