Here's How You Tell If A Trading System Is Setting Up Itself To Die
It is not uncommon to see a nice, good trending strategy that is so profitable for a while but then without any warning, it just collapses and suffers big drawdown.
And there are many such examples.
These are some real world examples of how they fail furiously, and often suddenly.
There seem to be no tell-tale indications to predict such catastrophe is about to happen.
Hence, it often goes unnoticed until the last moment when investors see their account associated with the system had diminished suddenly.
Until that unfortunate moment, these systems, trade pretty consistently, with a nice performance track record to show.
Without warning, they are gone.
There must be a way or method to detect it before the big fail, but the current statistics and metrics only calculate past trades which are pretty useless to project the future outcome.
So I decided to search for answers.
Using my background in engineering and working with mass amounts of data sets, I finally found a way to identify the root cause for the sudden fall and then I formulated a predictive indicator to unveil hidden risk in a trading system.
Surprisingly, it is a fairly easy method, but pretty good in revealing hidden risk-taking which often leads to failure.
I am calling this, the Expectancy Chasing Ratio. This tells how much money or position size is required to chase after a unit of profit that is $1.
A lower Expectancy Chasing Factor value is more desirable as this tells us a system is using a smaller amount to earn $1 and is not betting high to chase after this.
Placing bigger bets have a significantly higher degree of risk exposure, thus succumbs to market volatility easily. Volatility is the venom that destroys a system even though proper money management is often undertaken.
Therefore, the Expectancy Chasing Ratio (ECR) is a smart way, and a new way, to tell if a strategy is chasing after a unit amount profit with large trading volume.
A higher the ECR value means a higher chance for the system to fail. This is a predictive indicator to determine if a system has a large probability of causing serious account damage over the course of time. And is best to avoid them.
A trading system must not exceed a critical ECR number which has the highest chance for it to roll over and die.
That critical ECR threshold is 8,000.
Below is a chart in log scale comparing ECR between trading systems.
A system should immediately reduce the trade or position size if the ECR is at or above 8,000 based on my research. I have seen all the systems that suffered a sudden drop in equity has an ECR above the critical number.
This early indicator could identify if a trade position size is getting dangerously high and that can lead to critical account damage thereafter.
ECR below 8,000 are in a safe zone.
Here is how you tell.
You have to take note the expectancy of the system or strategy.
Expectancy is how much money or pips the system will make or lose on any trade. If the expectancy is $10, then we know on average, each trade can fetch $10, regardless what the winning rate is.
If the strategy's expectancy is -$5, then this is a loser.
Now, here is the trick to tell which strategy is risking too much on a trade.
You have to look at the historical trades and identify the biggest lot size the trader had placed on ANY single trade even if this is done on just one trade.
Now, if the biggest lot size traded is 1 lot or $100,000 equivalent and the expectancy of the system is $10.
Expectancy Chasing Ratio = largest trade size / expectancy
Instantly it alerts me that this strategy is risking too much on a lot size to earn $10. If the trader makes trades exceeding the ruin number, than it is at great risk to collapse in a matter of time.
GENESIS ASSET MONITOR is my copy service strategy that has been making a consistent return to myself and my clients.
Let's look at my system's ECR value.
Genesis Asset Monitor expectancy = $20.37
Largest trade size 0.06 lots or $6,000
So, the Expectancy Chasing Ratio = 294
This is way too less than the critical 8000 level. In fact, Genesis Asset Monitor's ECR is a lot lower.
Therefore, it tells Genesis Asset Monitor system is NOT risking too much for the $20 return. As long as my system trades well below the critical 8,000 number, it is trading safely.
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About the author
Ramesh is an active trader producing over 200% gain in 2017 and author of 3 trade strategy development books sold on Amazon. He is the creator the 10/20/30 Rule™ that could transform a mediocre trading system to become a top performer by following a systematic and thoughtful approach on strategy development.