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My Journey through Losing Marbles and Position Sizing™ Strategies: Part 3 by D. Witkin
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My Journey through Losing Marbles and Position Sizing™ Strategies: Part 3
This week's article is Part 3 of a three-part series from an excerpt of a new book that Dr. Tharp is working on due out in late 2012. This book will be a compilation of Dr. Tharp's insights as well as personal stories of transformation from traders. You can read Part 2 of the series here.
While I found a number of the concepts in Van's book Trade Your Way provocative, the most potent for me by far was the power of position sizing™ strategies. Position sizing strategies are simply the part of the trading system that answers the question “How much will I risk on this trade?” Sounds simple, doesn’t it? It is, and it isn’t.
Not All Lessons Are Equal
What if I told you I would put you into a fully-automated trading system with the following characteristics: it wins 35% of its trades but when it wins, the winning trades average three times the size of the losers. What if I also told you I had traded the system for 25 people, each in a separate account, for the last 10 years. While some years were better than others and the system was in negative territory for at least a portion of every year, all of the last 10 years were profitable for every account. All of the accounts were with the same broker, started with $100,000, and had exactly the same commission structure, and the system only traded liquid markets. Sound interesting?
Here’s the twist: while the system made money every year, the percent gain realized was very different for each of the 25 accounts, ranging from 4% to 95% gain last year and from 2% to 72% the prior year. The previous 8 years showed similar ranges of performance. The performance was independently validated by a credible accounting firm and found to be completely accurate.
But how could this be? Remember, this is a fully automated system—the trades are entered and exited automatically, everyone had the same starting equity, took exactly the same trades, and exited at the same time. Small differences in percentage gains across accounts could be accounted for based on slippage, but slippage couldn’t come close to causing this range of differences. What is going on here, you ask?
The answer is varying position sizing methods. Each trade was exactly the same for each account with the exception of how much money was risked on each trade. The owner of Account 1 risked 0.5% of account equity per trade, had the smallest drawdowns, and the smallest gains every year—the account owner’s objective was to minimize drawdowns. The owner of Account 25 used a more complex position sizing strategy, which risked more and more money as the account equity moved further into positive territory. Account 25 experienced significant drawdowns, the largest being 65%. This account owner’s objective was to make at least 50% per year even if it meant a maximum drawdown of up to 80%.
These sample accounts show just two possible methods of using position sizing strategies to achieve objectives—a number of other position sizing methodologies could be combined to provide thousands of possible strategies. For example, most traders recognize the importance of volatility in markets and, while this is not universally the case, many traders feel more volatility equals more risk. So what if you took smaller position sizes when the market displayed significantly higher-than-normal volatility (e.g., double the average true range measured over the last 90 days)? Or what if you combined position sizing strategies by risking 1% of account equity except when the volatility goes above some predetermined threshold? Each of thousands of position sizing possibilities could result in a different ending equity level despite taking exactly the same trades.
You might think I started using what I learned from the book to my advantage right away, and to some degree I did. Over the following years, I continued to trade lightly, still somewhat shell-shocked from my earlier losses. I continued to learn and test systems, but never to the point where I was comfortable enough to trade them with real money. I kept reading books by Dr. Tharp and began accepting some concepts I rejected earlier, like the importance of objectives. I continued to take some newsletter trades; some won, some lost. On balance, I probably broke even. Regardless, my trades were too small to make a significant impact on my bottom line.
Too small, that is, until 2004. Late that year, I decided I would be comfortable risking some money on a “proven” mechanical system. I searched the Internet and found a system designer who sold me two complementary, black-box systems—you don’t see the logic underlying the system, just the trades it spits out—for about $3,000. The backtested results were excellent—collectively, with a position size of 1.5% of equity on each trade, the two systems returned better than 50% per year with a worst-case drawdown under 35% over a 25-year period, and the results were reasonably consistent across years. I removed myself completely from the trading equation by finding a Commodity Trading Advisor (CTA) to trade the systems on my behalf and waited for the money to roll in.
About two years later, I closed the account after losing 50% of my money. Ugh. Again, I thought I’d made good decisions, carefully researching the systems to buy and allowing someone else to trade them mechanically on my behalf. Unfortunately, it appears the system designer curve-fitted the results. Curve-fitting means you optimize the system on historical data until you get results that look fantastic. The problem with curve-fitted systems is they tend not to do so well in the future. This was another lesson learned the hard way: if you don’t know how the system was tested, there is a good chance it wasn’t tested effectively and the results aren’t worth the paper it is printed on.
For the next few years, I did little trading and primarily just watched the markets and continued reading and learning.
Finally, Some Winning Marbles
In early 2010—almost 10 years after buying Trade Your Way—I thought I might be ready to try trading again. I was still scared of losing, but I believed if I kept my position sizes relatively small, I could stop trading if needed and limit my losses. To promote discipline, I created a few simple rules to guide my trading:
- Never risk more than 2% of total account equity on any trade.
- Always enter a stop-loss order along with an entry order (my broker allowed both to be entered at the same time as linked orders—very helpful).
- Reduce my position size or just get out if I start to feel uncomfortable.
- Use trailing stops to exit the market.
- Focus on trading two low-risk ideas: (a) channel breakouts and (b) bounces off support.
- Enter trades only when I believe there is a good reward-to-risk ratio of at least three to one.
- Get out of the market completely for at least two weeks if I experience a drawdown of 35%.
- If a position is going against me or taking too long to move in the direction I thought it would move, I exit before the trade hits the stop loss if I no longer feel good about it.
Based on a systems development workshop I took from The Van Tharp Institute in 2004, this set of rules was not even close to what he would consider a comprehensive trading plan. Nevertheless, I did enough things right to catch and capitalize on some big, very profitable trends.
I still lost more trades than I won—I think I only won about 30% of my trades. However, the winners were big, and I did well. As of December 31, my account value was up more than 130%, and I had yet to experience a drawdown greater than 20%. I was excited, so much so I took screen shots of my account equity each time I reached a new equity high, almost as if I needed visual evidence that my results were real. As much as I wanted to have a year where I made 100%+, I wasn’t sure I could really do it.
I firmly believe looking for good reward-to-risk trades and using a reasonable position sizing method were the most important factors in my results. The scientist in me is the first to admit there was some luck involved on individual trades—but it would be hard to make the case that luck was a major factor on the 100+ trades I made over seven months. Even with all my mistakes, I used enough of Dr. Tharp’s principles to knock the proverbial cover off the ball.
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“Gratitude is not only the greatest of virtues, but the parent of all the others.”
—Marcus Tullius Cicero
Yesterday, my wife and I played a round of golf with another couple at our Newark, Delaware country club. We just happened to meet the couple when we arrived, so we decided to all play together. The husband is an engineer in the aerospace industry. The wife happens to be my children’s pediatrician.
We were enjoying the unseasonably warm afternoon in November and as we walked down the 6th fairway, we marveled at the beauty of golf. Even though the ball sits still and no one “defends” your shots towards the green, getting that little white ball into the hole on a consistent basis is beguilingly difficult. This applies to weekend golfers as well as professionals: great golfers have won a major championship only to fail to make the cut in any tournament, large or small, in subsequent years.
Golf and trading share many similar characteristics. In order to perform them well, you need a certain level of skill. Like being good at accounting or cooking, being good at trading requires some level of knowledge. Unlike accounting or cooking, a baseline level of knowledge is insufficient to guarantee success because golf and trading require something extra: a mastery of self. These types of pursuits require a lifetime of learning and practice.
Taking What the Market Gives You
There is an old saying that traders have to “take what the market is giving.” When the markets are not providing consistently good profit-making opportunities, we have to be satisfied with smaller profits or even holding our own (not giving too much back).
Like good golfers, good traders don’t win every time. In fact, I wrote a few months back about legendary traders who were down 30 – 40% for the year. Across the board, many top traders and funds are still struggling. As of the close on November 18th, the Dow Jones Credit Suisse Core Hedge Fund Index is negative 6.27% on the year.
That brings us to a very seasonal thought for those of us in the US. Five weeks ago, our neighbors to the north celebrated the Canadian Thanksgiving holiday. And this coming Thursday, Americans will take time out to give thanks as well. Among delicious turkey dinners and the hope of good football games (What? The Detroit Lions are actually good this year?), we can pause to express our gratitude for so many gifts.
If you’ve had a rough year in the markets, relax. It’s been a rough year even for the best traders. Forgive yourself for your performance, endeavor to learn from this year’s trading, and be thankful that we are able to participate in free markets.
Regardless of whether you’ve had a great year or one that was less than stellar, the ability to trade the markets provides benefits for which you and many others can be thankful. Be grateful that by supplying liquidity and risk capital, YOU are providing a valuable service to our economy. Your role as a speculator provides the grease that makes the economic machine run more efficiently. Because of you, transaction costs are lower for long-term investors, and more investors can be involved in the markets. Because of you, consumer prices are lower since markets are more efficient. Because of you, credit and equity are available to companies that need it to sustain or grow businesses.
Beyond being grateful that you play an important economic role as a trade, you can step back and be truly grateful for every breath you take, every hug you give or get and every life that you touch. Thanksgiving is more than a holiday. If you allow it, thanksgiving can become a way of life. Someone you know needs a hug, a kind word or a phone call that’s been put off for too long. Don’t wait; go give someone else a reason to be thankful right now, while you’re still thinking about it. That would be the best Thanksgiving celebration you could give yourself.
To sum up,
- Know that as a speculator you provide a valuable service to society.
- Remember that as a person, you can make each day a Thanksgiving Day by doing something to make someone else feel thankful.
- Allow yourself to enjoy being grateful (it really does feel good!).
- Lather, rinse, and repeat. (Do this process over and over.)
About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".
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