Quote from feng456:
I have reduced size because it's gotten to the point where if I don't I will get a margin call. I've been through bad drawdowns before but nothing even close to this. I am currently down 35 points and normally I am down at most 25-30 (which happened once in all my data). Historically I have never been down this much in all the backtesting I've done.
Also historically speaking, December has not been a weak month. In fact, I do not have weak months that repeat annually. It's fairly random.
I am very disciplined as a result of learning from my past mistakes about the alternative but it is really hard to follow your rules when you lose almost every single trade...when you 80-20 win rate turns upside down and suddenly u lose 80 and win only 20.
I designed my leverage under the assumption that the worst drawdown in the backtested 4 years (prior to now) was the worst it could get so now since it's much worse, I am getting wiped out.
You made a few mistakes:
1. You didn't backtest long enough. 4 years is not enough. 1 market is not enough. Back test for many years across multiple markets.
2. You didn't do an out-of sample test. If you use 2005-2010 to backtest and work out your strategy, you need to then test a different time period - if you system doesn't work in the out-of sample period, it's probably not a profitable system, but just a data-mined fluke.
3. You assumed the strategy would go on working. You had no method for noticing when the strategy had stopped working. Thus, when it happened, you got caught by surprise. The fact is, markets change, systems degrade and stop working, so you have to be prepared for that eventuality, and have a plan to notice it and respond in timely fashion. Another poster (dom993) already gave a good example of how you can use standard deviation and monte carlo analysis to detect when a strategy is busted.
4. You didn't reduce your size after having a larger than expected drawdown. Any drawdown is one of two things - either a bad run in a still-working system, or the start of a system degrading and no longer working. The longer and bigger the drawdown, the more likely it's the latter (strategy failure) rather than the former (bad luck). Thus, the more you lose, the less you should risk per trade - you must follow a reverse martingale approach once your drawdown exceeds the normal level anticipated by your system's prior results.
I must say, as a discretionary trader, I see systems traders make these flawed assumptions and mistakes very often. There is something about systems trading that attracts rigid logical thinkers. And rigid logical thinkers (engineer/scientist/quant types) usually tend to overlook the importance of getting assumptions right. They concentrate mostly on deriving accurate conclusions from a given set of assumptions, but pay too little attention to the critical importance of making sure those assumptions were correct in the first place. A bit of lateral and creative thinking, and healthy scepticism about initial axioms, would go a long way to avoiding this mistaken approach. The best solution is to find a creative discretionary trader with plenty of market experience, and ask him to double-check your system for mistaken assumptions, risk blindness, rigid and close-minded design & thinking etc.
Unlike engineering, trading requires flexibility and the ability to detect when the 'rules of the game' have shifted. Markets are not a fixed and static system like bridge-building or unbiased roulette wheel statistics.
There are some general risk-control maxims you should consider, they should make your trading approach more robust:
1. Murphy's Law - if something can go wrong, eventually it will
2. Real-world results are usually worse than results in testing. Sometimes, they are much worse.
3. Thus, always plan for the worst case, not for the best.
4. A system is only as good as its assumptions. If you haven't analysed the robustness and validity of the assumptions, then you haven't analysed the system.
5. If you haven't considered every possible future outcome, and developed a plan to respond appropriately, then when one of those possibilities you didn't plan for comes to pass, you will not respond appropriately.
Good luck.
