Trading strategies have drawdowns.
Some even fail.
And failed strategies can kill trading accounts, so…
How can traders distinguish a failed strategy from a drawdown?
Here’s 6 ways to detect if a trading strategy is failing, from trading champion Kevin Davey @kjtrading:
1. Analyze Historical Performance
Compare the current performance with historical data.
If the strategy has exceeded basic metrics like maximum drawdown or number of consecutive losses, it might indicate a failure.
2. Statistical Process Control:
Use more advanced statistical methods to monitor the strategy’s performance.
This helps in identifying deviations from expected outcomes and determining if the strategy is still valid.
3. Probability Cones:
Use probability cones to get a more informed view of future performance.
This can help in understanding the potential range of outcomes and whether the strategy is likely to recover or continue failing.
4. Market Conditions:
Assess the current market conditions and compare them with the conditions under which the strategy was designed to perform well.
If the market has fundamentally changed, the strategy might no longer be effective.
5. Monte Carlo Simulation:
Look beyond a single equity curve to get the full picture.
Multiple equity curves can provide insights into the strategy’s robustness and potential weaknesses.
6. Regime Performance:
Understand the periods in which the strategy should perform well and when it shouldn’t.
For example, a strategy might struggle in a low volatility, sideways market, indicating it might be time to pause or adjust the strategy.
Most importantly, make sure you have predefined rules for when to stop a strategy.
This prevents emotional decisions during drawdowns and ensures disciplined trading.
Full Interview
Watch my full discussion with Kevin:
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