First of all, I hope all our readers find this blog in good health in this pandemic. Dear readers, just remember tough times don’t last but tough people and tough individuals always do (this is not just a hypothesis but proven over and over again in the history of mankind)
Now coming to the main topic, you must have noticed that from the last 1.5 months market and especially main indices making moves here and there with no clear trends. This is called time correction in the broader market, where markets have no major triggers for the price stretch on any side. In this time correction, assets are not losing its value faster like March 2020 but it is testing the patience of many traders. Specially most of the trend -following systems are gone for the toss in this period. I think many of you may also have faced some Draw-down on their system and are hoping for new equity highs. Well I am also in this list!
Now, as our system goes into DD, some of us will start questioning our beliefs on the system that is it really broken or is it just another bad period and soon the system will make new equity highs? Some traders also abandon a good system in this phase without assessing all facts. To give an example, we have a Mean-reversing model(MRDT) that we are trading live with subscribers, back in December 2020 witnessed around 30% DD from equity peak. It was way above the historical DD of 17% that in the Backtest! At that time many of our subscribers(including some good traders that traded this system) abandoned the system. But what happened is, well you can check below self-explanatory Equity curve! You can check all details here.
But if we expected to have just 17% DD by looking at the back-test report then why have we not stopped trading this model after it endured two times the expected DD? There might not be a single answer for this but what we believe is when assessing any systems’s backtest report if you are not happy with twice the expected DD and half the expected refund then you should definitely not trade it.
This is what we do while analyzing any model/systems! Because your biggest DD is always going to come in the future when you are going to trade system live, not in the back-test report! So, we have to plan position-sizing accordingly!
Now, there are also experienced systematic traders who will abandon the system once it encounters more DD than backtest report. So, should you also? Answer of this question is very simple: what is your expectation about return and DD profile about this system? At the time of backtest have you taken the assumption that I am going to have only this much DD, and if it takes more than that then I am done with the trading system! If yes, then though you may abandon the system but you are still going according to your initial plans irrespective of your emotions and impulses! So, this is a sign of a matured trader.
Hope I have made my point. Another quick thing to add is it has been observed across the trading systems that, if the system is robust enough then deep DD will always be followed by Higher Equity at the end! So, without questioning and wondering much as they say, “Just put down the next trades!” If you have risk management in place then in the longer run You will always do good!
I would like to conclude this article, by putting extract of Jack Swagger’s interview with legendary system trader, Richard Dennis in the Market Wizards,
When I was going to interview Richard, the serval public fund he manages was on the verge of 50% DD, a catashropic event in the life of any trader!
Perhaps one of Dennis’ most impressive traits as a trader is his ability to go through such hard times with little emotional impact. Apparently he has learned to accept such sporadic large losses as part. His confidence during such periods remains unshaken, as he believes he will eventually rebound if he stays true to his basic trading strategy. Had I not known, judging by the mood and confidence of the man interviewed, I would sooner have guessed that he had just made a small fortune rather than lost one.
Until then stay safe!