How to reduce drawdown

[oliverpenn]

Does anyone have any effective methods to reduce draw down for long term trading strategies? Primarily ideas on how to determine the size of a stop, or how to determine a suitable position size?

Has anyone read the Kaufman book on trading methods, worth the investment?

 

[marky]

Hi oliverpenn , the amount of draw down you are prepared to handle is relevant to the time frame your trading and how good your entry is, if your able to buy in close to the bottom you will not suffer much draw down, if you enter part way through a circle but in the correct direction again the draw down is relevant to the time frame, so in my opinion the entry is the most crucial point . hope this has helped.

Regards Mark.

 

[oliverpenn]

Thanks for that Mark. I have a system that I have back tested that seems to work quite well. It works well in that you have more money than when you started. It works quite well in that the draw down is quite horrendous.

As I'm sure you have seen, there are members on these boards who post equity graphs of their trading accounts. These show very small drawdown which is something I would like to be able to incorporate in my system. In fact, I'm quite jealous! I was just wondering if anyone had any ideas as to what methods were being used here?

Are you a professional trader or just fascinated like me?

 

[marky]

Hi oliverpenn , i day trade the ym, or the dow future, but not for a living but like alot on here that is my aim, as for your draw down i think that is only something you can decide upon, ever bodies pain threshold is different, i would say have a good look on this bulletin board as im sure there is more than enough information to help out, personally i like small time frames and are fairly good at picking bottoms so draw down is not such a problem, if you can incorporate the use of patterns in your system it may well eliminate some trades and therefore the trades you should really be on may not suffer with horrendous draw downs, in trading you never seem to stop learning, hope i have helped you out.

Regards Mark

 

[TheBramble]

Primarily ideas on how to determine the size of a stop, or how to determine a suitable position size?

The first and most important factor in reducing drawdown is to have an effective risk and money management system in place.

The second is to have effective entry and exit criteria defined.

The third (and least important) is to have some method of selecting which instruments to trade.

The other thing you need for which without, the other three are quite useless, is the willingness, discipline and confidence to stick to your risk and money management, your entry & exit criteria and instrument selection like glue!

To provide something a little more concrete than just the bare advice given above, I've attached my Stop Loss and Position Size Calculator.

It's setup to calculate for directional trades and pair trades on stocks, but should be usable (in essence) on other instruments. (If you're not into pair trading you can ignore that side of it.)

All you need to enter is your trading capital, the share price and the bid/offer spread on that share. (Or for pair trades, just the two stock prices).

I've also added notes to show the basis of my calculations - and it's all very simple. It's based on a methodology employed by another t2w member - Grey1 - to whom all credit for this system belongs.

Entry & Exit Criteria and Instrument Selection is a very personal thing, as is the timeframe in which you choose to trade.

 

[Rainmaker]

A key element to reducing drawdown is diversification. If you are trading a portfolio of instruments and they are highly positively correlated, then drawdown will be high (especially if your individual position sizes are large). A basket of uncorrelated instruments will not move like sheep and a large adverse movement in one will be cushioned by the rest of your portfolio.

 

[oliverpenn]

Thanks for that guys, some very informative ideas coming out. My system will (eventually!) be fully automated so discipline and emotive issues will be eliminated.

I tried daytrading for a while and didn't really like it. I found there was too much screen staring involved, but I'm sure it suits some people. That's my main motivation to build a EOD system, although at the moment I am back testing strategies using Java apps with the hope of actually trading some soon.

I think what I have got to do is build in some TA into the entry criteria to stop getting into poor trades. Also I need to come up with a method to decide the size if the trade depending on recent performance, ie increase size when doing well and decrease when doing badly. But how to mechanically decide if the system is doing badly is difficult, in people's opinion what metric would be suitable? I was think something along the lines of:

if ( x out of y most recent trades where losers AND I lost z pounds recently) THEN descrease size

Any ideas? Thanks for all the above posters, they really got me thinking.

 

[TWI]

If your system is going to be fully automated why do you care if it is an EOD or intraday system?
Unfortunately large drawdown can be an inherent property in mechanical EOD systems. It is hard to find a set of criteria which when applied consistently will always make good entry descisions. In my experience intraday systems allow you to keep better control of these drawdowns. You may have seen discusion on T2W about systems which are as simple as if market makes new high/low at xhrs then buy/sell and close yhrs later or something along those lines. These simple systems do tend to give you smooth equity curves as they trade often and trades are of a short duration so drawdown is limited, the only key is to make sure the smooth curve is going the right way, takes account of slippage and has not been simply optimised on historical data.
As for sizing your trade, I would tend to base this on market volatility/range rather than how your last trade has gone. Surely each trade is an independent event for an automated system and the system is not emotional like the human animal that requires such rules.
This is of course just my opinion.

All just my opinion.

 

[oliverpenn]

Thanks for your post twalker, initially my EOD system will be manual, then moving on to fully automated. The idea of a fully automated intraday system scares me a little as I'm a bit worried about coming home from work one day and finding I'm short thousands of contracts. But it's a long way off yet, actually need to find a system that works first! I've got ideas of using a Java app interfaced with IB as this seems quite straightforward when I've been playing around with it.

I agree with you now about each trade being an independent event, so I'm thinking about basing the size on a function of ATR or another volatility metric.

Do you trade for a living or just a keen hobbyist like me?

 

[ithomas21]

Have a look at the turtle rules at:

http://www.originalturtles.org/

That system uses ATR to specify position size - might be helpful.

 

[TWI]

Oliver,
I trade for a living, spent about 10 years working for others before going it alone.
Most of my system experience has been with tradestation. I found this a good tools for construction, testing and monitoring. I have yet to find something I prefer, the various versions are discussed in other threads on this forum.
Good luck with the system, my advice is to keep the rules as simple as possible, for every variable you introduce you increase the possible instability.

 

[TheBramble]

A basket of uncorrelated instruments will not move like sheep and a large adverse movement in one will be cushioned by the rest of your portfolio.

Providing you're market neutral with your basket.

The other concern with a basket approach is that although you're cushioned (potentially) from adverse movement and large losses, you also limit tremendously your profit potential.

 

[TheBramble]

I think what I have got to do is build in some TA into the entry criteria to stop getting into poor trades.

You'll always be getting into poor trades. You'd be better off IMO having a simple stoploss system that you adhere to to cut your losses short.

Also I need to come up with a method to decide the size if the trade depending on recent performance, ie increase size when doing well and decrease when doing badly.

Increasing your trading size after a string of successes is not a good idea. Statistically, that's when you're more likely to get into a loser.

Maintaining a trade size consistent with your capital regardless of performance seems a sensible way to go.

However...

Trade size is best reduced after a number of consecutive losses. We all get 'cold' periods and halving your trade size each time until you're back on track doesn't hurt. Capital preservation is key.

Some suggest at a BIG loss point (say 5 or 10% of your capital) come out of the market for a period (week, month).

 

[TheBramble]

Have a look at the turtle rules at:

http://www.originalturtles.org/

That system uses ATR to specify position size - might be helpful.

Yes, but they also used a market volatility factor, their trades ran for months, they traded commodities and in enormous size.

It's not that this wouldn't be a good read for OP (or anyone else for that matter) - it is very interesting.

But their approach wouldn't suit OP's intended plan of action.

It also has to be said, the majority of Turtles couldn't stick to their founders designated approach and discipline and thus failed to make profits overall.

 

[ithomas21]

They used ATR as the market volatility factor.

I suggested it only as a guide to position sizing, not for the rest of the system.

For example, to set a 2% loss at twice the ATR you could use something like this:

No. of shares = (Account size * 0.02)/(2 * ATR)