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.