YOU KNOW what I am talking about if you have spent any amount of time in the markets. You have a wonderful system that is pulling profits in by the truckload, or at least consistently. Then, out of nowhere, it has one loss, then another, then another.
Puzzled, you look at your entries, conclude that you were trading your system just fine, and continue to play the game…
…and you get another loss. Then another. And another…
Unless you’re a seasoned veteran who knows his trading system inside out (in which case get in touch with me – I’d love to hear from you), this is where the nervousness begins and those butterflies in your stomach become full-grown fire-belching beasts.
What the heck is happening?!
To cut a long story short, your system just entered a payback cycle. A what, you may ask? A payback cycle. You won’t hear of this on the novice websites, but if you’ve been in the markets long enough, the real traders will recognise this phenomenon.
Your trading system’s probability will NOT remain constant all the time. Indeed, it is constantly in flux. (Which is why Martingale systems can be a very bad idea, especially because are used to thinking in terms of fixed probabilities…) Some days, it will go swimminngly well for you. Your probability will be 90% for maybe 10 trades in a row, or perhaps more. Then, it drops to 30%. Or maybe 20%.
That’s where the rubber hits the road…
If you designed your system well, you would have squirrelled away all those gains from the winning period to survive the lean times. If you traded haphazardly, then woe betide – you probably will not have enough to survive this.
“What can I do about this?”
Basically, nothing can stop the probability flux of systems. They are all susceptible to it. However, when you reach a certain point in your development as a trader, you will be ready to accept that it is better to proceed on the assumption of poor probability and good risk-reward. That means that when you’re right, you get many times what you risk.
Incidentally, this does NOT mean you have to stubbornly stay in a trade that is clearly going against you because your target isn’t reached. If price is telling you that this isn’t the one, it isn’t the one – you let go and move on.
However, you must design a system to at least have the potential to deliver extremely large returns. Trust me, it will make all the difference in the world when probability flux strikes…
Not convinced? Think about this…
Imagine you have 2 systems with exactly the same expected return in a backtested period of oh, say 5 years. One has good probability (say 70%) and poor risk-reward. The other has poor probability for good risk-reward. Which one would you choose?
Ideally, the backtest (and forward test) results should hold, and the systems should produce the same results. In that case, System 1 with the good probability is much easier on the psychology.
HOWEVER, Murphy’s law applying, the systems will likely go through probability flux. Think about it…if your probability is already as poor as 30-40% and you are making money, is a drop in the win rate to even 10% going to break the bank? Probably not. The system is already designed to survive lean times. It may not make money, but it will not lose as much ground. Furthermore, when things go back to normal, it will relatively recover quickly. And what about when probability flux goes in your favour? What if the probability shot up to 70-80% momentarily? That would be serious money in the bank for you.
Depending on how it’s designed, System 1 will either go into a prolonged period of drawdown, or it will blow up the account. Because it is designed to scalp quick profits from the market, System 1 will have to pick up a lot of pennies to make up for its losses. If it did not avoid taking large losses, it could even potentially blow up the account as worst case scenario.
Newbies never want to hear this, because they like the quick fix of the high win rate. That’s usually sub-optimal in the long run, to say the least.
With best wishes for your trading,
Private Fund Trader/Head Trader Consultant
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