How Much Pain Can You Take? Risk, Hindsight, Consistency And Paper Trading

The risk is real, and trading is not easy.

The above quote is from page 110 in Curtis Faith’s The Way of The Turtle. A great book! This sentece captures the essence about trading: a very difficult endeavour that ultimately leaves your inner strength exposed. It all looks so easy when looking at fictive equity curves. Just follow the rules and just rake in the money. Yes, sometimes there is a drawdown*, but the graph shows an upward slope immediately after. Looking at it from an ecological perspective, drawdowns are like prey – necessary and natural to get rid of the weak players.

However, most people learn the hard way (including me) and realize it is not so easy after all. A strategy might yield 10% per year, but along the way you experience nasty drawdowns. Can you handle that? Do you know where your psychological limits are? How much pain can you take before you abandon the strategy? Is 30% an accepteble drawdown? When looking at many years of equity curves (and not exponential curves) a 30% drawdown looks so tiny on a chart. But in real trading when real money is at stake, such a drawdown is not small anymore. Do you continue trading? Do you stop? I feel pretty confident when I say that most people would quit. This is especially true if you trade only one system/strategy. So in order to succeed for the long term you have to understand how drawdowns can change your decision making process.

Peter Lynch had an incredible good track record for a long time when he managed his fund. But to his astonishment, the vast majority of his investors were not even close to obtain his numbers. Quite a few actually made a loss. Why? Because they buy the fund after it has risen, and sell after it has fallen. They do the complete opposite of what you should do. Therefore, it’s so important to develop a strategy which you can follow. And I believe a system with less drawdowns are much easier to follow. That does not necessarily mean lower returns for the long term as long as you follow the strategy (vs. theoretically better returns with bigger drawdowns – but less likely to follow).

Currently I trade this gold strategy. This one is pretty hard to follow. Drawdowns once in a while is many percent. One day I was long and holding overnight, but GDX was down 2,5% at the open. According to the strategy I should reverse the position and go short. Every inch of my contrarian body resisted going short. Luckily I followed my rules and GDX fell a whopping 3% from open to close so I managed to recover my overnight loss. It’s so important to follow the rules! And just as important to have many strategies. The GDX strategy is just one of many I currently have.

Your goal in trading is to make money, but you have to preserve capital to make sure you can make money. Sounds like a contradiction, but it isn’t. You have to remember that time is on your side. If you have a positive expectancy you’ll make lot of money. But to make money you have to take risk, and that form can either make you: 1. stop trading after a drawdown (which will happen sooner or later) or you can 2. have a spectacular loss and lose much of your capital. That’s why you have to become familiar with your risk tolerance before you start developing systems and strategies. And when you start trading, start small until you have some years experience. Risk managemnt is a trade off between risk and reward. You have to find the balance between losing too much or leave too much on the table. You can never know in advance how much heat you can absorb until you start trading. Everything looks so easy using hindsight. But when you’re in the middle of a severe drawdown you never know if the strategy has stopped working or if you’re in the middle of a “normal” drawdown.

Think about this: if you lose 10% of your capital, you have to make 11.11% to get even. If you lose 30%, you have to make 42.85%. By 50% you have to make 100% to get back!

Also worth noting: The longer you trade, the bigger the drawdowns. There is no problems finding a strategy with a history of less than a couple of years that has minimal drawdowns. A longer history will simply capture different markets for a strategy. You also have to take into consideration the frequency of your trading. The law og big numbers can be used to your advantage.

Concistency

One of the most important factors to succeed in any trading endeavor is to be consistent. Of course, when you have a big edge, you can trade bigger. But in order to build confidence in your trading you have to be consistent. When you have become consistent over a long period, you can increase size and trade more agressively. If you’re not consistent, how can you determine if you’re lucky or really good (if you make money)? There is an enormous element of randomness in the markets, and there will always be a lot of traders making money simply by chance. You might have found a strategy that makes money, but that strategy only works in a specific market. When the market change, you start losing money. Curtis Faith writes this:

The most important lessons in life are simple yet difficult to execute. In trading, concistency is the key. A systematic trading approach, a through understanding of the limitations of that approach, and the tools used to build trading systems can help you be more successful and constant. You must be consistent to trade well. You must be able to execute your plan or the plan has no meaning.

I think Mark Minervi in the Stock Market Wizards have nailed it. He gets the final words in this article (page 175):

I think paper trading is the worst thing you can do. If you’re a beginner, trade with an amount of money that is small enough so that you can afford to lose it, but large enough so that you will feel the pain if you do. Otherwise, you are fooling yourself. I have news for you: If you go from paper trading to real trading, you’re going to make totally different decisions because you’re not used to being subjected to the emotional pressure. Nothing is the same. It’s like shadowboxing and then getting in the ring with a professional boxer. What do you think is going to happen? You’re going to crawl up into a turtle position and get the crap beat out of you because you’re not used to really getting hit. The most important thing to becoming a good trader is to trade.

*Drawdown is simply the amont of loss between equity peaks. Let’s say you started with 100 000 and one year later you have 130 000. However, in year two you suddenly end up with 110 000 in equity, ie. the drawdown is 15,4% from the peak.