Newsletter of Danny Merkel - Issue #152

Risk Management:

I recently discussed the topic of losing streaks, something that every trader will inevitably experience, yet is rarely ever talked about.

In order to make my point, I presented an hour long video, a quote from Trading in the Zone, and several spreadsheets.

However, learning about risk management is boring, and I doubt many people got through the entire video. That’s unfortunate because risk management and position sizing will have a greater impact on your profitability than any other aspect of trading.

Teaching the importance of position sizing in a way that was fun and exciting remained an unsolved challenge until one day I came to the realization that Van Tharp’s “marble game” could be replicated using a standard pack of cards.

You might be thinking that there’s no way to simulate the stock market using playing cards. And you’d be right - this game only illustrates certain aspects of trading, not the entire market.

The way it works is that you take a standard deck of cards and you pick out only those shown in the photo above. Your new deck should now only contain 22 cards.

From there, the game is played like Blackjack where one person is the dealer, and you could have 1 - 5 players who are playing against the dealer.

The dealer starts by shuffling the deck of 22 cards and each player makes a wager before a card is dealt.

After all players make their bet, the dealer selects a card from the deck. If the card is a “face card” then each player loses whatever their bet was and the money goes to the dealer. This represents the harsh reality of Trend Following trading that most trades lose money.

On the other hand if the card is, for example a 3, then the player triples their bet. The best card a player can receive is a 9, in which case they win 9X whatever they bet, so this shows that Trend Followers occasionally nail down a huge winner that pays for the many small losses.

Once the round is over, the card that was dealt is re-inserted back into the deck and shuffled. The game continues until all players run out of money, or until the dealer runs out of money.

Now this game may seem quite simple, but it actually illustrates seven key concepts that are absolutely critical for trading success:

1. You can lose money most of the time, yet still be profitable. Just like many Trend Following strategies, the game loses money 64% of the time. But as Ed Seykota says “one good trend pays for them all.” Said another way, as Dan Zanger puts it“You can afford to be wrong when your winners are 10 times the size of a small losing trade.”

2. You don’t need to know what is going to happen next to make money.

   In other words, the outcome of your next trade is out of your control, just as you cannot control the next card that is drawn from the deck. But as a trader, you can control your bet size to ensure that no losing trade/card ruins you. You can create positive expectancy by cutting each loss quickly while allowing each winner to run.

3. When you control your bet size, one trade/card just doesn’t matter. If you’re doing Trend Following right, then one trade should never make you or break you. If you take a trade and it doesn’t work out, then just cut the loss and move on. As Nick Radge says “think next one thousand trades”.

4. There is a random distribution between wins and losses for any given set of variables that define an edge.

5. Due to this random distribution, you will experience losing streaks due to chance. For example, let’s say a new trader is willing to lose 5% of his account capital per trade. Okay, what happens if you have 10 losers in a row? In fact, using pure math, I can prove that over the next 1,000 trades, you will likely experience 15 losing trades in a row given the game’s low win-rate of only 36%.

6. Anything can happen. Even if you use stops, you can still get blown away by a gap down in the market. That is illustrated by the presence of Jokers in the deck, where you get stopped out way below your stop loss level. The only defense against the Joker is to ensure each bet is small. Go all-in on a trade and get hit with a Joker and you’re out of the game. As Ed Seykota says, there are no old, bold traders.

7. Losing money doesn’t mean you made a mistake. The outcome of a single trade is mostly random, so don’t take it personally if it doesn’t work out. If you followed your process and you bet small, the best thing you can do is move on quickly to the next trade. Given that the game has a positive edge, you want to bet often, so don’t let a losing trade slow you down.

This simulation illustrates all of the same essential lessons of Van Tharp’s marble game (read the book Super Trader for details), but is much easier to setup, given that most people have a deck of cards lying around somewhere, but probably don’t have a bunch of different coloured marbles on hand.

As practical as it is to setup up this game, I’m excited to introduce an even easier way to put this simulation to the test.

All of the playing cards can be programmed and displayed as a website, which is exactly what has happened.

The way it works is that you start off with $1,000 in cash and you get to choose how much you’d like to bet on your next trade:

From there, the website will randomly select a “card” from the deck and you will instantly know the outcome of your next “trade”.

One of the advantages of this website is that you can simulate a large number of trades by rapidly clicking on your desired bet size.

For example, following a golden rule of trading and risking 1% per trade, we can see what happens when I took a thousand small bets:

After a thousand trades, the size of the account grew from $1,000 to $5,701. Though that’s a respectable growth rate, there are some difficult realities that lie beneath the surface.

Firstly, the system didn’t make any money throughout the first hundred trades or so. Thanks to some bad luck, the strategy didn’t gain any traction and most new traders probably would have given up, especially after facing 18 consecutive losing trades in a row.

After the first hundred trades, the money does finally start to tumble in and the equity curve begins to rip higher.

Towards the end, another losing streak occurs and the strategy records a maximum drawdown of 41.17%.

So, yes, it’s a money making trend-following system, but can you stomach 18 losing trades in a row and a 40%+ drawdown?

If not, you can always make the choice of betting smaller. This will lower drawdowns, but also reduce performance in the long run.

Alternatively, you can also increase your bet size above 1%. Given that the system is profitable, shouldn’t bigger bets mean bigger profits?

You can try for yourself, but you will see that big bets usually (though not always) lead to bankruptcy.

In this case below, a greedy and reckless 10% bet size blew up the account after just 27 trades:

To give the game a try yourself, click here.

Finally, I’d like to give credit to ufinz.com for taking the time to program this website and allowing anybody to try it out for free.