Inspired by this brilliant StockTwits podcast with Peter L. Brandt, we want to talk about a concept that turns potentially profitable trader into consistently losing ones.
To make it short and painful: there is no perfect trading strategy and how well you can deal with losses will determine your future success as a trader – more than your actual trading strategy will. Yes, there are HFT outfits that have been posting winning day after winning day for the last 5 years, but let me tell you a secret: you are not a billion dollar HFT firm. Plus, even if such strategies do exist, the chances of coming across one of those during your lifetime would be extremely small.
So stop hoping, and start accepting the fact that you will lose. A perfect trading system is one that makes money in the long run, not a system that makes money with every trade – that is utopia.
Curve Fitting Is Asking For Disaster
If, even after your trading system has proven to be profitable, you still want to make it better, you have to be very careful. A trading system is a very complex construct and whenever you change a parameter, the other parameters are affected. For example, aiming for a larger target to increase your reward:risk ratio will probably also reduce your winrate more trades won’t reach your target. Or, when using a tighter stop to increase the win:loss ratio, you will probably also see a drop in your winrate because your strategy is more vulnerable to volatility. And is is the same with every other parameter of your strategy.
Changes to a trading system should be subtle and step by step, based on robust data. If you constantly try to perfect your performance, you will eventually end up curve fitting. This means that your strategy will be too closely aligned to the most recent past which leaves absolutely no room for any changes in market behavior in the future. But as we all know, markets are breathing and constantly evolving.
Fitting a system too tight around past data will cost you a lot of money – the very real dilemma of every backtest.
At One Point You Have To Decide Where You Stand As A Trader – And Expect To Lose
You may already have a profitable trading system in your hands, you just don’t know it because after every losing trade you want to change something so that the loss you just took could have been avoided. However, this means changing your system and opening it up to other potential losses; the term traders use here is “hindsight trading”.
At one point you simply have to accept that your trading system will lose trades, it is the nature of trading. Traders have to make decisions under uncertainty. Uncertainty equals risk; but without risk, there would be nothing to gain in trading. In Poker, no one would ever even consider the idea of trying to win every hand he plays; it’s a ridiculous thought and absolutely insane.
Accept that this is you, that this is your trading system, with all its benefits and flaws. Learn to love it and accept that losses are a part of it. If you have proven yourself that you have an edge with a positive expectancy and that the system makes money for you – what more do you want? If you are serious about this, put in the work and have realistic expectations, you have a much higher chance of succeeding than most other traders who keep running from one method to the next.
You Have To Strive For Excellence, Not Perfection
If you cannot fulfil your dream of creating the perfect trading system, what is left? Excellence! It is your job to make sure to follow your system 100%. Not even the slightest deviation is allowed. Make sure you are always trading at the peak of your performance. Strive for excellence and make every trade count!
Every trade that you take outside of your trading system is an insult to yourself, to the time and effort you put into trading, and to your self-respect.
Excellence really comes down to respecting yourself in the end. Once you come to respect yourself and trust your abilities and your system, it will become easier and easier for you to follow your system.
If you encounter a losing streak, research whether you executed all the trades flawlessly and if yes, did the market conditions have changed, or did anything else happen? During losing streaks it is essential to stay on course and follow your system, but at the same time understand why you are losing. If there is nothing to be done, good. This describes the process-oriented mindset which we discussed earlier.
Take the losing streak with pride, protect your capital, execute every trade with excellence and you will weather the storm.
Instead Of Optimizing One Setup, Simply Master Another Setup Or Market
It’s fairly simple, really: Once you followed your system for a while (let’s say 50 – 100 trades) with the utmost excellence and you are still losing money, you can say with very high certainty that the system is the problem. You can then adjust, but you will never know if your system is a winning or losing one if you don’t follow it in the first place. That’s what demo accounts and backtests are for.
And trust me, the more emphasis you put on thoroughly following your system, the faster you will develop it into a winning system that fits your lifestyle and personality, which is incredibly important.
However, if suddenly you are winning over a sample of 50 trades – wow. This could be it! You may have a winning system. Why change it now? You are making money. Trade the system until you can do it blindly, day in, day out and execute with excellence. If your trading journal tells you that there is a LOT of potential in a certain area – go for it. Test the adjusted system on demo first, of course. However, if you are profitable and can’t find any huge leaks in your journal, leave it as it is. Again, do not curve fit.
If you get bored, that’s great! The hallmark of excellent trading is monotony. You have mastered your setup, congratulations. You can now, in order to smooth your equity curve and diversify your income streams, develop another setup following the same process.
Over time ,you may learn 3-5 setups to find trades in every market condition and your equity curve will look almost perfect, although there will still be a lot of losers among your winners! But never add a new setup if you are not making consistent money with the first one.
“Multiple systems, traded over a wide variety of markets are necessary to smooth out the equity curve.” Joe DiNapoli
Conclusion: Never Change A Running System
What definitely holds true in the world of bits and bytes also holds true in the world of trading. Once you make it, be happy with it. Do not question your system, ever, unless you consistently start losing money. Curiosity killed the cat.
With a professional trading journal and a good feedback loop it is very easy for you to test alternative strategies, see where you are leaking money, find out in which areas to improve, and so on. It will also help you tremendously in executing your trades with excellence and building discipline with the immediate response features, such as the Tilt-meter.
Don’t be greedy, don’t be a perfectionist. Be an excellent trader that knows that losing is part of the game.
This article was published originally on Edgewonk.com