One step ahead – New groundbreaking Research Part 3

From the Share Wealth Systems R&D Team

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Where to start a system revision process?

In the previous blog we discussed the research objectives and today I’m going to focus on the actual process.

Ultimately the two main outcomes that a trader would like to control is the degree of risk (drawdown) and the degree of reward that they would like to achieve in their portfolio within the constraints of:

• • How much capital they have to trade with.
  • How much time they have to devote to the trading process.
  • What their risk profile is, measured mainly by how much drawdown they can tolerate.
  • Their trading methodology (includes trading system, risk management and money management). The only things that a trader can control are what they trade, when they trade and how much they place in their trades. These three decisions for every trade ultimately determine their drawdown and returns.
  • The level of their trading psychology.

We know that active investors have a diverse range of maximum drawdown or pain they can tolerate ranging from < 10% to as much as 60%. However, most investors would use similar position sizes and risk management criteria in their trading, despite having very different drawdown tolerance levels. This doesn’t make sense. If one investor was prepared to risk 10% of portfolio capital while the other is prepared to risk 60% then risk management and position sizing has to be different. The reason that most investors don’t see this from the outset is that:

• • most books contain similar suggestions about money management, e.g. the 2% and 6% rule, and,
  • there are very few functional portfolio level risk and money management tools available and those few are priced above the range that the great majority would be prepared to pay for such functionality. Also, most retail investors wouldn’t have the knowledge and/or time to research to this level because it simply is not discussed in popular main stream books, i.e. we don’t know what we don’t know.
  • Most investors tend not to consult with themselves and ask how much drawdown can I handle. It’s only after the pain threshold is reached that investors either throw in the towel or search for a solution.

So if the two main outcomes that a trader needs to control are their level of portfolio drawdown and their portfolio returns, what is the main determinant that controls these two outcomes? The answer is: the risk and money management controls that are used for each individual trade and for their overall portfolio. The position size is THE biggest determinant of size of outcomes, both positively and negatively.

To be able to achieve one’s reward objectives whilst remaining within one’s risk objective constraints becomes the main balancing act that a trader needs to manage on an ongoing basis.

This means that a trader requires as much flexibility as possible with their risk and money management rules to have the confidence to increase and reduce position sizes (even to $0) as required to increase returns without overstepping their stated risk objective, found in their Trading Plan Objectives Statement.

The degree of flexibility that a trader can have with their risk and money management rules is determined by the variation of individual trade outcomes which in turn, when combined with risk and money management rules, leads to the degree of variation of potential portfolio equity curve outcomes, in terms of return AND drawdown.

This is a key, possibly THE key statement in this material. Ensure that you grasp it. If not now, then return here when you have read the entire set of blogs.

This means that the more similar each trade is to another the more flexibility a trader will have with their risk and position sizing rules which leads to a higher confidence level of achieving their anticipated portfolio outcome, as stated in their Trading Plan Objectives Statement (see Blog on 29 Nov 2011).

Therefore, making each trade as similar as possible to each other becomes a trading system design objective in order to reduce the variation of possible trade outcomes.

To achieve this, specifically the two main measurements to improve within the trading system are to reduce End of Trade Drawdown (ETD) of individual trades and to improve the Win Rate of the trading system. This is the place to start the revision process, with ETD and Win Rate of the trading system which will then flow back to risk and money management.

Now that I’ve laid out the logic behind the research, we’re going to move into the meaty stuff. Please don’t be scared as I plan to convey my message simply. I want to leave you with the idea that to improve your trading results you must look at things differently than you do now. So my primary goal is to challenge and possibly change your thinking so that you can take this knowledge and improve your results.