Every week I receive a handful of emails from other traders who send me a copy of their strategy to evaluate. While I rarely if ever have the time truly required to go through each one and properly backtest it on my own (at least the way I would with any strategy I would use personally), I must admit it is always interesting to see what people come up with on their own. While not always the case, 95% of the strategies I see are derivatives of others I’ve noticed already although most come with a few tweak here and there. Frankly, it is rare now that I come across such an odd-ball strategy that I haven’t seen in some form somewhere before.
While I’m honored that others would think that highly enough of me to share their strategy, usually it is done for the one of the following three reasons: 1) a trader trying to show how smart they are especially if the strategy has been performing well (i.e. hey look at me and how smart I am!), 2) the trader is stuck and wants me to help them make the strategy more profitable and/or want some advice on how to do it (i.e. usually this follows if the strategy is no longer working as well as it has in the past or the backtesting was more impressive than the real performance) and 3) there has been something recently that has hurt the strategy’s performance and the trader is desperately seeking answers to understand why everything went wrong (i.e. the system is broke and I can’t fix it, please help me Kirk!).
Which brings up an important point – if you don’t know the weak points in your strategy, it isn’t because they don’t exist but rather you haven’t discovered them yet! In my experience, no strategy out there doesn’t have some sort of soft spot (or many) whether it be it doesn’t work in some markets, that some event could cause a drastic loss, or even user error. As Curtis Faith once wrote, “With experience, one realizes that there is no such thing as a perfect system.”
When I work closely with other traders on their strategies in the mentorship group, I often talk about the Battle Of Waterloo and how it relates to trading in general and specifically strategy development. If you don’t know the battle (which I recommend reading about if you have time), just listen to this once popular country song and you’ll get a sense to why I think this is so important.
While I’m no historian, I do think traders can learn a lot about trading through learning about important battles in history. The Battle Of Waterloo offers a great example as it offers many lessons for us to consider:
Make your planning and risk analysis commensurate with the size of your project. For major endeavors, contingency plans are critical.
Know when to cut your losses if necessary. Don’t let your desire to succeed be the enemy of good judgment.
Be sure that the justification is clear for your project, and that your entire team is sold.
Don’t become over-confident, especially after many successes. Remember the basic principles.
Never attempt an unpopular endeavor in isolation.
Don’t make enemies. You are only as good as your allies.
Adopt leader style politics, not the Machiavellian style. Look for the win-win.
Many of these lessons apply to good trading, especially the ones about the importance of having contingency plans, knowing when to cut losses, having clear justifications for your trades, the importance of avoiding overconfidence and finally how important it is to attack from a strong position like having plenty of capital and cash reserves.
Needless to say, every trading strategy has their own weaknesses. So, what the most common weakness I’ve found? That’s easy – human error. That’s right, usually most strategies that have been backtested and proven to work continue to work well unless we do things to either deviate from the plan and/or we apply leverage to it rendering it extremely vulnerable. It is fairly often that I see traders come forward with a hot strategy they’ve used and are in the process of levering it up, creating havoc and exposing themselves to great risk. There is good reason for the expression – leverage always kills. In my experience, that has been true. Beyond that, many strategies are based on things that don’t account for the constantly evolving nature of the market.
In sum, every strategy you employ needs to also have a list of “warning signs” that will indicate whether you are facing a Waterloo-like defeat. You can rest assure those in charge of the quant trading systems have this in place already on Wall Street. From my experience knowing and working closely with others who do that for a living, they all have checklists every day that tell them whether the system is “operating within normal parameters.” When the performance falls outside of that, the quants know to put the brakes on. Do you do the same thing with your own strategies? If so, then do you have a system in place to know when you should put your trading on hold?
While you can show me all kinds of stats on how good a system may be, but what I want to know is what will cause all of those performance figures not to hold up in the real world. Bottom line you must ask yourself what could happen potentially to cause the strategy not to work or cause you a significant loss? Sometimes that’s not possible to know especially when evaluating a new strategy, but just having some suspicions when working with a new strategy can often prove to be a true asset.
So, how do you learn its weaknesses? Backtesting can help, but what I call forward testing helps even more. In my opinion, nothing will replace the experience of watching the strategy day in a day out coupled with how it reacts to different market environments over a lengthy period of time. That will provide you with hints when there is real trouble ahead. Like most things, there’s nothing going to replace your experience with the system. The experience is also necessary to build the level of confidence you need to maintain and improve it as well and to reject temptation to abandon it when it doesn’t perform up to your expectations.
Remember, all traders sooner or later come to understand and appreciate that it is only a question of when, not if, they are going to be on the wrong side of the key trade. Strategies, even ones that work perfect on paper, will always fail at some point sooner or later on. The only question is how to utilize the strategy the best you can up until that point AND to be able to pull the emergency chute when it threatens your capital in a significant way.
So, next time you’re working a strategy that is making money hand over first, take time to ask yourself this simple question – Where will you meet your Waterloo? If you can always answer that question to some degree, chances are good you never will!
* This report was originally published for members on November 3, 2010 at the members’ only site.