The difference between a successful trader and a losing trader has a lot less to do with the successful trader’s ability to pick winners than you might think. All traders are going to experience losers and lots of them. It’s a fact of the business.
A winner, however, embraces the understanding that a large element of any one trade is randomness — in effect, any given trade is, on some level, a gamble. Losing trades are inevitable, and the winner takes that inevitability into account. Many longtime successful managers have done it with a winning percentage just above 50% and even the best traders are right only about 60% of the time.
It isn’t necessary to achieve that success rate to profit in the long-term, though. It isn’t even necessary to be 50% right (see "Win some, lose some," below). The depicted scenario assumes a 40% win rate — in other words, eight winning trades out of 20. The key to making a 40% win rate profitable is to structure your trades so that your winners profit at least twice as much as your losers lose — and that your initial stake can withstand the inevitable string of losses.
Look no further than recent headlines to illustrate this. Numerous ill-informed analysts have made the point that former MF Global head Jon Corzine could end up being correct on his positions in foreign bonds. No, no, no. When you take a leveraged position, you are not simply speculating on the direction of the market, you also are making a market timing decision and a position on volatility. You limit how far the market can go against you before you must bail.
Consider the assumptions in our table. Our hypothetical winning trades yield a profit of $2,000, and the losing trades lose half of that amount. Of particular significance is that even though 60% of the trades are losers, after 20 trades the overall balance is a positive $4,000. However, at one point the overall balance was $4,000 below water.
Indeed, the order of the winners and losers has a major impact on how your account grows. In "Splitting our losses" (below), we depict the same 40% win rate, but the sequence varies with two large blocks of losers separated by a string of six winners. The ultimate final profit is the same. However, in this case we got there after suffering just a $3,000 drawdown.
Why losers lose
The issue here should be obvious. You can’t predict the order of trades and must be prepared for the worst. Say you start with $8,000 and that you need at least $2,000 (the initial margin requirement) to make each trade. If you have eight losers in a row, you are broke. In fact, six losers in a row and you are shut down, taking into account fees. You can’t last through the full 20 trades. Rather than making $4,000, you are shut down with massive losses when your account dips below $2,000.
The worst case scenario is that you could lose 12 straight trades and then hit eight straight winners. In other words, to make the $4,000, you would need more than $14,000 (the losses plus the initial margin) to even begin trading. The likelihood of such a string of losses is remote, but it could happen.
That is the reason that most traders end up losers. They don’t allow for the possibility of a major string of losing trades. The truth is that while the worst-case scenario may be unlikely, something approaching it has a relatively high probability of occurrence. Over time, it is a virtual certainty that at some point all traders will suffer a long series of losing trades.
Keys to winning
However, it is not that hard to develop a trading strategy that has a win rate of 40%. It is also not that difficult to structure trades that produce a two-to-one profit/loss ratio. Given that, the only factors preventing a trader from succeeding over time are not starting with a large enough account size and succumbing to the temptation to over-trade.
In the initial example, the trader needed $4,000 more than the margin requirement to make the trades. In the second example, $3,000 more was needed. In the worst-case scenario — 12 straight losers and then eight straight winners — the trader would need $12,000 more than the initial margin.
To demonstrate, consider an approach designed to achieve the minimum desired performance metrics: 40% wins and a two-to-one win ratio. Our tests cover dollar index futures from Jan. 19 through June 3, 2011. The rules are simple. On Jan. 19, we buy or sell the close based on a coin flip. Heads we buy, and tails we sell; in our test, the coin toss was heads, so we buy.
Regarding the profit/loss ratio, if price moves in our direction by two standard deviations, we take profits and initiate an opposite trade. If the market moves against us by one standard deviation, we take a loss and initiate a trade in the opposite direction. Our strategy is designed to manage our profits and losses to achieve our goals. The initial coin flip simply gets us into the market in an objective manner.
The goal of this strategy is that if we win, we’ll make two standard deviations. If we lose, we’ll lose one standard deviation. (A standard deviation is a statistical measure of price movement, or volatility, and virtually all charting programs offer it.)
Understand that this approach is for demonstration purposes only. The buying and selling is being done in this manner to achieve close to a two-to-one profit/loss ratio. There is no reason to assume that the trades will work, as the only logic is a volatility measure designed to set profit and loss points at desired levels.
The results of this one demonstration reinforce the contention that the most important thing about a strategy is sizing the account to allow for a series of losers — that is, proper funding. It is much more important than the ability to pick winners (see "Random results," below).
The margin on the dollar index is about $2,000, and the first trade was a loss of $840 so we would have needed at least $2,840 to begin trading. In reality, we would begin with an even larger account for security’s sake, so let’s use $3,500 as our base number.
Of the trades that were made, five were winners and eight were losers. This is approximately a 38% win rate. The overall profit was $920, or $204 a month on average. The average loss was $572 and the average winner was $1,100, so we came close to achieving the goal of a two-to-one profit/loss ratio. Projecting those same results over 12 months would yield a profit of $2,448, or about a 70% annualized return on the initial account size.
We also tested the results of this approach based on starting with a tail on the initial coin toss. In other words, the first trade was a sell, the second trade was a buy and so forth. These results also are shown in "Random results."
The strategy performs much better starting with a sell instead of a buy. The profit was $5,200 rather than $920. There were a total of 17 trades, and nine were winners — just a little better than 50%. The average winner was $1,032, and the average loser was $511. The annualized return using $3,500 as a beginning balance is a strong (and unlikely!) 396%.
An interesting observation from "Random results" is that the last three trades in the examples were the same. In other words, our strategies converged. This is possible because interim volatility levels that trigger an opposite trade for a loser may not do so for a winner. This would allow the winner in the first hypothetical scenario to ride, while the other scenario would have switched directions. If the subsequent move is enough to hit the trigger for both, then each strategy will stop-and-reverse, and they’ll move in tandem. (It would be interesting to test this approach in other markets and time frames to see how long it would take the scenarios to converge given other circumstances.)
Trade structure and money management are critical for all traders. The futures markets move, and that movement presents a steady flow of opportunity, but the techniques used to capture that movement are secondary to proper trade structure and starting with enough funds to weather the drawdowns.
There is no system for entering and exiting a trade that will make you money in the long run if you fail to follow the rules of trade structure and money management. Eventually, the system will break down, and you will suffer a string of losses. Accept that and plan for it, and you will enter the ranks of winning traders. Ignore these facts, and you will remain with the majority of traders who lose.
Our goal is not to replace a signal generation program with a random model but to point out that proper risk management and position sizing is as important as signal generation.
Discussed here has been a broad framework for achieving success in the markets, but there remain holes in a proper discussion to formulate a workable strategy. Specifically, these include how to determine the worst-case scenario for determining how to allocate sufficient capital. We’ll examine this in a future article.
Joseph Stuber began his career in 1972 as a research analyst. He is an author and lifelong student of risk and risk management.