Any time I hear of someone blowing up a trading account, particularly if they’re using a strategy anywhere remotely close to mine, I always take time to reassess my risk protocols. The human side of me (isn’t that my only side?) worries that their misfortune is contagious, that I too might succumb to ruin.
To the extent that this knee-jerk reaction causes me to once again cast a discerning eye toward my trading systems, and their accompanying sizing and risk measures, it’s a good thing. More often than not, my analysis reveals that my methods are sound and my risk of ruin is nil.
Upon concluding that my approach passes muster, I wisely turn my attention elsewhere. Continually fretting over my methods because some other naive or unlucky fellow blew himself to smithereens is counterproductive.
For illustration purposes, let’s rehash the metrics of the Cash Flow Condors system to see how it would fare under adverse scenarios. If you’re new to the game here at Tackle Trading, this system involves selling monthly high probability iron condors on the Russell 2000 Index.
Per the deltas on our short strikes, our forecasted win rate is around 85%. If reality follows expectations, then we should lose anywhere from one to three months a year.
If we exit at the short call or put strike the loss is usually around $300 to $400 per contract.
Losses In A Row
Rookie traders smartly focus on risk per trade but often overlook what will happen if they suffer a series of losses. It is these losses in a row or LIARs that take the greatest emotional and financial toll. Withstanding a losing trade is one thing. But suffering through a spate of four, five, or six (or more!) money-stealing trades in a row is another beast altogether.
In the backtest conducted for the Cash Flow Condors system the longest losing streak was two months. But here’s the deal with backtests. I view them as a proof of concept, not a script that will be followed moving forward. I’ve heard it said that the worst ten year period of a backtest is the next ten years. And there is undoubtedly some truth to that.
One day the Cash Flow Condors system may experience three or four or more losing months in a row. Don’t fret about such an eventuality. Instead, prepare yourself with proper sizing and hedging tactics. Let’s compare two approaches – one reckless and one conservative.
Ricky is a gunslingin’ chap too trusting of others. Some shmuck named Tyler says Cash Flow Condors is a sound system so what the heck, let’s roll with it!
The Rickster has a $10K account and decides to deploy five iron condors a month which ties up $5K. Since he enters every 60 days to expiration, he holds two months simultaneously which means his $10K is fully committed.
After a few winning months, Ruin arrives unbidden and altogether unwelcome. Poor Ricky suffers three, nay four, losing months in a row. Down $350, Down $300, Down $400, Down $350. And, remember, that’s per contract. Multiply it times five, and we’re talking a $7K loss or 70% of his account.
And, yes, I realize he couldn’t have continued doing 5 per month due to his dwindling cash pile. This is my pretend scenario, not yours.
Dejected and depressed, Ricky quits condors to try his hand at Cannabis stocks.
Colin is a grizzled veteran with a scar-riddled body that’d make a Navy Seal wince. With his $10K account, he deploys one iron condor each month. He too enters 60 days to expiration and holds two positions simultaneously.
The same four losing months takes his account down a total of $1,400, or 14%. And that’s assuming he didn’t hedge at all. Do you see how Colin exits this drama relatively unscathed and certainly unphased? A 14% drawdown is far from career-ending and nowhere near Ricky’s 70% oopsie.
Size properly and render Ruin impotent. That’s the truth about LIARs.
Financial freedom is a journey
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