When a mechanical trading system is having a drawdown what do you do?
Suppose you’ve subscribed to a “star” system and one day find your broker account losing money as the system has entered a drawdown. Volatile markets expose trend-following systems to a higher chance of false moves which lead to losing trades. You’re tempted to unsubscribe. Ironically, it’s when we give up on such system it frequently comes back with a big winning trade that pulls it out of its drawdown.
So should you pull the plug now or perhaps there might be a smarter option?
Sophisticated money managers use methods which seek to extract extra profits during a system’s down phase. For example, moving averages can be applied to a system’s equity curve. Called trading the equity curve, this technique marks the system out of sync with market conditions when its short-term average of the equity curve gets below above a longer-term average. “Paper trading” during this phase increases your odds of not taking trades which are likely to turn out losers.
If you’re a WealthSignals subscriber, staying on the sidelines is not your only choice. As the odds of the winner trade appearing soon are increasing, the trade size can be added to each time a losing trade occurs. While this sounds counter-intuitive, backtesting suggests that variations of this Martingale money management may actually improve performance:
Losing streaks: After each losing trade, slightly increase the next trade’s position size step by step until some upper limit is reached. Stop the increase if the losing streak gets too big, and get back to original size after a winning trade.
Reverse trade: When the next trade has a higher chance of failure, be it a losing streak or system’s equity staying “under water”, don’t suspend trading. Instead, execute the signal in reverse — go short when a buy signal occurs and vice versa. Those with appetite for risk may increase the trade size.
Not every type of system can be “reverse traded” like that, and “over managing” is a double edged sword. Professional traders know that for a robust system with positive mathematical expectation, every losing streak or drawdown will eventually end. If a WealthSignals system has a proven track record, an equity dip may give you the edge and offer a lucrative opportunity to subscribe!