How to Manage Initial Drawdown – Two methods to start a new stock trading system

Starting Up A New Stock Trading System

Have you ever looked at a new stock trading system (or have developed your own) and wondered HOW TO START trading the system?

Do you just start taking the signals the system generates? How big will the initial drawdown be? Is there a better way?

This video explains 2 approaches to starting a new trading system and how you can determine which is best in your situation…

This video was taken from a recorded coaching call with a client from my Enlightened Stock Trader Certification Program. If you would like to learn about trading with personalized interactions like this, then click the button below and answer a few simple questions about your stock trading (even if you haven’t started yet!).

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So we're talking about initial drawdown.... and when we start training a system what happens and how do we make the choice about what we do when we're studying the system.

So when you when you've gone through the whole system design piece and make the decision to go live with your new stock trading system, there are two ways to do it the first and most common way is to take every trade that is triggered from now on.

What that does is it ensures that your initial risk per trade is contained. Because say for instance you initially risk 2xATR which you equate to say 1 percent of your total account on each trade. But as a trade grows you usually use a wide trailing stock for instance. The instantaneous risk on each individual share could be quite wide.

So most people start by taking new signals so that the the risk on each new trade that they put on is contained. The trouble is you don't have any of the old trades in your portfolio that are already winners because they were triggered before you actually started trading.

So the second option rather than starting taking every new signal the second option is to on day one replicate the portfolio that you would be holding had you always traded that system.

And if on day zero just before we started trading your theoretical portfolio was full on day one when you start trading even to take trades which would literally fill up your entire capital.

The disadvantage is if that trade the theoretical portfolio had held for three years now turns around on day one it starts falling. It's going to go a long way down before it hits its exit point.

The flip side will the benefit of that approach is that if that trade is already a winner it keeps going up. Your portfolio keeps going up.

So it's a trade-off between having and the initial trade drawdown. The initial drawdown occurs because you're getting losing trade losing trades losing trades waiting for winter to come through and drag a portfolio up because that's that's difficult to cope with as we'd found out. But eventually you make money you just know that each loss is going to be easy because it's small.

The tradeoff is you don't have the initial trade drawdown. You actually get to take a sampling out of your historical long term equity curve from the back test. And that's a lot more likely what you'll get. But you may have a trade that has a big dollar loss that's painful.

If you want it to replicate the portfolio that you would have been holding, You just start the back test you know 20 years ago...and run it forward. Say you start with $100000, you ran it forward and on the day we're going to start trading that system the equity curve is at three million dollars. Assuming you've got to have the same position sizing model through the entire backtest, take all of the positions that are in that $3000000 backtest portfolio and scale them to the amount of capital you're allocating to that system today. So then the position sizing becomes reflective of what it would have been had you always traded that system.

But you know it's a lot of execution on one day you get a lot of risk on each individual position. If the market turns down on the day you start trading or soon afterwards then you end up turning down having no real built up profit because it's all starting capital.

So if you were going to do that you want to be really comfortable with the worst case drawdown and you got, and design your rules or position sizing and portfolio management with that in mind. Because that is the drawdown you risk getting initially.

Compare this with the usual approach of starting to take new signals in the day you go live. In that case you've got to be comfortable with the initial drawdown.

How do you get comfort with the initial drawdown?

You can't just run a 20 year back test. You've got to start the back test at different times and see how big the initial drawdown can be. You might start at 20 / 30 / 40 different points in time and backtest from there to test the size of the initial drawdown.

In most automated trading software you could simulate that or replicate that by having optimization variable that says trade entry date must be greater than X and then step X for say one month at a time for 20 years and then look at the range of possible initial drawdowns.

So what are the steps that take a big step back...

  1. Have your system rules done
  2. Do the optimization, stability and robustness tests
  3. Make sure your are comfortable with the initial drawdown. If you are not comfortable then you better make sure your position sizing is going to keep you comfortable so you don't freak out before you move into profit. Do the step of the start date with your current position sizing rules. Look at the range of initial drawdowns. Extract that automatically from most trading software by looking at the lowest equity during the back test. If you're uncomfortable with what that initial drawdown is go and change of position sizing / change your number of trades or go and change your exposure cap or your leverage level.

The chances are that your initial drawdown is usually going to be equal to or greater than the worst historical drawdown in a long term backtest.

This is because in a long term backtest you have got the benefit of winning trades from previous years coming in, so the ongoing drawdown is going to be lower because you are winning from day one on some trades in that portfolio.

So if you really don't like the initial drawdown but the loans and that test is amazing, you should probably adopt the other option for kicking off the system which is starting to trade as if you had always been trading that stock trading system.

 

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