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Avoiding Disaster: How to Conquer System Death for Good!

Education - AxiTrader Team | 28 May 2014

The views outlined by the author in this blog post are their own and do not reflect the views of AxiTrader. Forex trading is risky and is not suited to everybody. System death.

System death.

Forex trading strategies stop working. Edges disappear. Market conditions change.

The trader is left hanging, hopes unfulfilled.

But disaster can be avoided. You don’t need to experience system death, if you know how to tell if a system has stopped working before you lose money.

Understanding how to avoid system death has other benefits. If you have a pre-defined process for when you will stop trading a strategy, it gives you confidence. As Marty Schwartz, Wall Street’s champion day trader, said:

“Confidence is essential to a successful trader”.

You can trade with confidence and discipline, trusting in your rules to protect you, instead of worrying about if what you are doing has a limited shelf-life.

 

Why trading strategies stop working

The number one reason strategies stop working is that they are optimised to work in a particular market type. When the market type changes, the system stops working. The topic is covered in detail in this blog post. This could solve a lot of your trading problems.

Other reasons Forex trading strategies stop working include:

  • The strategy is poorly designed. For example, it is curve-fitted to historical data and is not robust enough to survive live trading.
  • The edge disappears. The reason for the system working no longer exists.
  • Trader mistakes. The trader is unable to trade the strategy efficiently, and it performs below expectations.
  • Position-sizing errors. The system may have an edge, but position-sizing errors cause it to underperform.

Plan for your strategy to stop working

It’s ok for a Forex strategy to stop working.

If you could have a high-performing strategy that makes a 100% return, but it only lasted for 3 months, would you use it?

Strategies that work and then stop are not a bad thing. The bad thing is to continue to trade them, not knowing that their time has come.

Here are some ways to plan for your strategy to stop working:

  • Trade multiple systems. Don’t keep all your eggs in one basket. Have at least two different strategies at any one time (preferably for different market types).
  • Position sizing. In your position-sizing rules, make sure you cater for the “worst case scenario”. In particular, protect your core capital.
  • Don’t become emotionally tied to your strategy. Sometimes, when the idea is yours, it can be difficult to let go. Don’t get your sense of self-worth wound up in your strategy’s performance.

More importantly, you want to have a benchmark of your strategy’s performance. Once you see a deviation from this benchmark, you can go into “high alert mode” and monitor your strategy closely to see if its performance recovers or simply stop trading the strategy altogether.

A methodical approach to managing system death

Avoiding system death is simpler than you may think, though it can be a bit of work:

  1. Track your strategy’s performance to create a benchmark.
  2. Notice when the strategy performs outside of expectations.

Note that you don’t need to wait until you are losing money to stop trading a strategy. Instead you can simply reduce your trade size as performance degrades.

Here is a specific method for achieving this:

  1. Benchmark your performance by placing 30 trades with a consistent small position size (like 0.5% of your account).
  2. Work out your trading strategy’s expectancy.
  3. Create a table to rank your system’s expectancy. For example:

Excellent Expectancy: above 2
Very Good Expectancy: between 1
Good Expectancy: between 0.5
Break-Even Expectancy: between -0.1–0.1
Poor Expectancy: below -0.1

4. As you continue to trade, track your expectancy over the rolling last 30 trades.
5. If your expectancy ever goes down a rating, you have a few options:

6. Reduce your trade size.

7. Allocate less of your trading capital to that strategy.

8. Stop trading the strategy.

 

You will need to fit this approach to your own trading methods

For example, your benchmark for excellent may be having an expectancy above 1 instead of 2. You need to base it on your own system’s results. So long as the method achieves its goal of protecting you from system death, the details don’t matter that much.

Let’s look at this in action.

You have benchmarked your performance and your trading strategy currently has an expectancy of 1.5.

As you trade, you notice that your expectancy over the last 30 trades has gone down to 0.9. When this happens you continue to trade, but cut your position size in half.

You also do a review to check where the fault lies. Perhaps it is simply market conditions are not so suitable, or you are making a mistake that you did not notice.

You continue to trade at a reduced position size and your expectancy drops down to 0.2. It is now dramatically different from the expected performance and you decide to stop trading it all together for now.

You have now avoided system death without losing any money in the process. Nice!

 

An alternative method of monitoring your system performance

Another method traders use to avoid system death is to monitor each strategy’s equity curve.

As the equity curve flattens or starts to go down, you would allocate less trading capital to that strategy; as the equity curve turns up, you would allocate more capital to that strategy.

Depending on your strategy, you might find this method more useful than the one above.

 

You have now avoided disaster and conquered system death!

By benchmarking your system and tracking its ongoing performance, you have a powerful tool to prevent losses while remaining confident and disciplined in your trading.

So it’s time to get to it! Knowledge requires action for you to benefit.

Keep the first step simple, and resolve to track your expectancy of the next thirty trades in your trading journal.

You can then come back to this post and work on creating a table and rules for adjusting your position size.

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