How a Bottom-Up Approach Can Introduce More Risk Into Your Trading
Let’s suppose that you just learned a new trading strategy. The back-tested results seem acceptable, so you decide to try it out on a trading demo. Overall, your “simulated” results seemed favorable.
So, you proceed to test it in the live markets. You are well aware of the trading maxim “stick to your trading plan,” so you conscientiously try to avoid anything that may cause you to deviate from you plan.
- 1st attempt, you make a position-sizing error.
Your position was too large; you lost so much on the first two trades, that when a profitable trade finally came about, you had very little capital left in your account. You wait for a period of time, say, around a month, to add more to your trading account.Error: your position size was too aggressive.
- 2nd attempt, you didn’t account for the frequency of trades.
You decide to minimize your position size. But now, there is something else you overlooked: this strategy, which can trade up to 10-times per day, is subject to losing streaks which historically had lasted for as long as 2 to 3 days before “recouping” its losses and generating a profit. But you would never have been able to complete the “anticipated” losing cycle simply because you ran out of trading capital.
Error: you didn’t have enough funds to trade the system according to what it required.
- 3rd attempt, you didn’t check the expected drawdown figure.
Feeling discouraged, you decide to go back in an attempt to trade the system correctly. This time, you are taking so many losses that your account equity is down a whopping 30%! You freak out, as would almost anyone, but then you cease trading the system. As soon as you stop trading, the system begins generating profitable results, all of which you end up missing.
Error: you didn’t check its “expected” drawdown, which in this case was around 35% average and 40% for worst historical drawdown.
- 4th attempt, you stuck with the system even when it stopped working.
You have decided to give this system one last attempt. Here’s the problem: you never checked the average and historical worst drawdown. You don’t know what might be considered “normal/abnormal”; acceptable/unacceptable; or expected/unexpected with regard to drawdown. This time, you sustain losses up to 42% of your account. You stick with it, however. In the end, you lose 60% of your account equity before finally calling it quits.
Two Errors: compounding the previous error, 1) you never set a critical loss limit for your account, and 2) the system you were trading exceeded its worst historical drawdown, a red flag that may have invalidated any of the system’s historical performance stats.
How a Top-Down Trading Plan Might Have Helped You
Although no trader can “control” market outcomes, every trader can at least set up a strategy for dealing with risk; a framework to tell you when a system or method is not performing as expected; a predetermined limit that defines when to keep trading and when to call it quits.
In other words, approach it from the top-down (a high-level perspective) rather than from bottom-up. It’s about first assessing your direction through the forest as to avoid getting lost amidst the trees.
Here are a few things to consider:
What kinds of returns are you expecting, and are they realistic?
What is your return expectation? If it is “as much gains as I can make,” then you are not approaching it clearly. Is your desired return even conceivable given your amount of trading capital (read: “risk capital)?
For example, imagine gaining or losing $1,000 on a single trade. Is that a large figure? It depends:
- If you have a $100,000 trading account, you would have made or lost 1%.
- If you have a $5,000 account, you might have made or lost 20%, which is a relatively large figure (if you profited, did you risk too much to gain that profit; if you lost money, perhaps you should have traded smaller).
Do you have a loss limit per trade, per day, per week, per month?
How much loss is too much? For instance, is a 2% loss per trade too large? What if your method trades 5 times a day? Are you comfortable losing more than 10% in a given day?
Or if you are a swing trader who holds positions for a period of days, how much can you afford to lose in a week or a month–4%, 6%, 10%?
Or perhaps your loss limit is not a percentage amount but a dollar amount, say a loss limit of $500 per day. If you have a $100K account, then your loss limit equivalent to -0.5% per day. But if you have a small $2k account balance, then you are risking -25% in one day which might be exorbitant!
Your preferred loss limit is up to you, as it is determined by your own financial goals, risk tolerance, and size of risk capital.
Does your preferred trading method or system match your expected returns and loss limit?
If you plan on trading a “scalping” system, one that trades 10 times per day with an expected stop loss of -$100 per trade, and if you have a $1,000 account, then realistically, you might not make it to the end of the day if you come across a losing streak.
If you trade with a $100,000 account, then you at least have enough capital to trade such a system. It’s common sense. Make sure you have enough funds to trade.
Do you understand the expected returns and limitations of a method or system?
Past performance is not indicative of future returns. No method can trade every single market condition. Some methods can stop working altogether for an extended period of time, or perhaps even permanently.
Understand your method/system well enough to know when to keep going and when to halt trading. Don’t just blindly “stick to your system.” If you are loyal to your system, know that there is no system that can possibly be loyal to you.
Remember, approach your trading from a strategic top-down perspective. Don’t just jump in and start trading, hoping that it all works out.
If you need more guidance on this matter, contact one of our brokers. We are experienced professionals who can help you better understand the risks of trading. And remember that to trade is to directly engage risk. So, trade wisely!
There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.