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Lessons Learned:
My point about having the most leverage........
I made a small fortune during the run up prior to March of 2000. I had days where I was making $20K a day net using ole Metastock (not even close to my best day). I was maximizing all the leverage that my broker would let me have. Occasionally, I would get a margin call since I was trying to stay right on the edge. I wasn't paying any attention to the risk I was taking. As you might guess, the combination of Max leverage and Max volatility in the underlying securities put me in an extremely risky situation.
When the down swing started, I had been faithful to my trading signals, so I hung in there following my trade signals, selling one stock after another as the signals were generated. In four days, I had sold all my portfolio. I didn't pay any attention to the margin calls, because they were coming fast and I was selling fast. When it was over, I was in a semi-state of shock. I had lost half my money in four days.... (not much comfort, but Soros lost a Bill in one day)
When I regained my composure (days), went back to review what went wrong. I followed all the signals and the back testing said I should've have faired better. Yet, I had indiscriminately bought anything that was volatile and gave me a buy arrow (using Metastocks Explorer). When I looked at the equity curves of those stocks with my trading system, the drawdowns were steep and had been that way for a life of the stock. The data was there the whole time.
Lesson 1 Learned:
If the stock interacting with your trading system has historical equity drawdowns of 30-50 percent, don't expect to avoid this in the future. In fact, the worst drawdown is probably still ahead of you. Know the stock you are trading (big gaps, volatility, equity drawdowns, sudden price collapses, can your system react, liquidity, etc.)
By liquidity, if a securities market is pretty much just you vs. a market maker, I know who will win that one. They will still ignore your order if they can, even today, causing what I call super-slippage.
The high leverage I was using really hurt. But it is great during the upswing. Big Double edge sword - leverage cuts both ways! Anyway, when I went back and backtested the securities I traded with 50% to 100% of Max leverage (how many of you have done this in Metastock?), then I started to see the nasty equity hammering that magnified the equity drawdowns. Those backtested results clearly showed what happened. The high leverage combined with high drawdown trading signals was my undoing. (Drawdown defined at the percent reduction in equity from your highest equity high).
Lesson 2 learned:
Your particular trading system doesn't matter much. How your trading system behaves with a particular security in terms of equity drawdowns matters a lot. How much leverage you apply to that trading system/security is the real ball game.
Example:
Which would you rather trade -
Security A that backtests a 25% annual return with a 5% max drawdown or Security B that backtests a 50% annual return with a 50% max drawdown.
Security A has a Reward - Risk ratio of 25/5 or 5.
Security B has a Reward - Risk ratio of 50/50 or 1.
(I now only consider trading a security if the ratio is 10 and the absolute drawdown no worse than 30%)
Now apply 50% leverage to these. They both get riskier by at least 50% (ie. drawdowns get 50% worse)- that is along as you don't get beyond the optimal F where you will probably lose everything (drawdown 100% - game over). There are three things going on here.
- The reward-risk ratio
- The absolute drawdown (5% in one case and 50% in the other)
- How leverage will affect each of these. (leverage is not linear, - the main point of Ralph Vince's Optimal F - whether you use optimal f or not, it is a mathematical fact that will cause your trading demise if you ignore the nonlinear impact of leverage)
Metastock doesn't have optimal F programmed in (I'm not sure that anybody else does either), but you can make a series of backtest runs increasing margin in Metastock. I'd take your favorite system and security and run successive backtests incrementing margin up by 10% each run. Plot the equity results for each run. If that isn't any eye-opener, then you've done something wrong. If your favorite stock has never had a major correction historically, then I would say that the biggest equity drawdown is still ahead.
More later if you are still interested...
Sincerely,
Kevin Campbell
In a message dated 7/12/03 11:25:06 AM Central Daylight Time, jojab@xxxxxxxxx writes:
Kevin,
Thanks for your post (and to JO as well for his).
You wrote:
"The "Holy Grail" is in money management not trading systems (buy and sell
arrows) per se."
I agree with you on this point. Would you care to share some of your ideas with the group as I think this would make for a useful discussion?
Good Trading,
Joe J.
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