Many traders understand that any given strategy has receiving periods where strategy will really well and burning off periods called draw lows where the strategy provides back some of the money it gained. This kind of reoccurring cycle of revenue periods and draw down periods is really because every strategy is made to capitalize on certain market patterns and/or market modes. By way of example if a strategy is made to capitalize on a clean upward trend, then that strategy can do extremely well during smooth upward pattern periods. But if a person trades that strategy during a different market mode than what it was designed for, like throughout a choppy market, then the strategy will experience a draw down period. fusionex
Traders intellectually know these profit periods and attract down periods occur, but in practice their thoughts get in the way of seeing these reoccurring cycles for what they are really. I have seen investors successfully trade an programmed strategy for multiple a few months, but then the strategy has five losses in a row and they quit trading it. That they say the strategy is suddenly broken or any number of other rationalizations to justify why they stopped trading a strategy that was working for them with good success. All sorts of various internal barriers come up for traders when they get into a draw down period. Many traders have an overly active risk nausea and this risk aversion triggers doubts and negative mental chatter so that it is difficult to think clearly. In essence the vast majority of dealers have never developed any rules for what they must do during a sketch down period. Since they aren’t sure what they should do, their brain chatter sets in and they make emotion structured knee jerk trading decisions.
I recommend that all investor have rules about get down periods including when to trade and when to not trade any given strategy. One idea My spouse and i find helpful is to actually monitor the collateral curve on each trading chart to give a third party objective view on the strategy’s performance. I’m not talking about the cost action on the chart; I am discussing about the actual fairness curve of the trading profit. When the fairness curve is rising, gowns when you should be trading your strategy. The moment the equity curve is dropping, that’s when you should paper trade that strategy.
Every strategy goes thru cycles of equity run-ups and equity draw lows. When periods of collateral draw downs happen, keep in mind that mean that there is something wrong with the strategy. When you should trade a specific strategy will depend on what market function that strategy was designed to take advantage of. If the strategy design is in sync with the current market function that is the time when that strategy is going to make money. If the strategy design is not in connect with the latest market setting that is the time when the strategy is likely to give back money. This kind of is the nature of all automated trading strategies. If you intend to trade an automated strategy you must understand these reoccurring periods and have rules to help you manage them.
Understanding these cycles will help you understand why there is no such thing as a “holy grail” trading strategy. Investors continually search for this mythical strategy that has an incredibly high ratio of winners and never has any draw down periods. No such strategy exists. If you find a technique that has a really high ratio of winners, almost all of time that strategy has an inverted risk reward proportion. What this means is the strategy utilized an increased risk approach and so the chance is too high for this to become a good strategy to trade. This method literally has inverted the golden rule of trading.