How Great Traders Do Not Lose Millions in Up or Down Markets

The year 2014 has, so far, been a very challenging one for my trend following system, with the Russell 2000 generating 4 whipsaw signals since January, yet making zero progress for the year.

As a trend following stock trader, I do not need a rising market to make money - I need a long term trend, either up or down.   The chart below shows the Russell 2000 moving in a choppy, erratic manner:

Not only have small caps not trended this year, but they have severely under-performed large caps, which has been another head-wind.

This year has some similarities with 2011 in this regard, but unlike 2011, there are also few other trends in other asset classes that have worked out (like silver or gold did in 2011), which is another head wind.

Because of these factors, my stock trading system is experiencing a drawdown.   This is nothing new, as my equity curve has been a rocky road since day one (which I argue is sign of robustness, not fragility).

However, here are 8 steps which I am prepared to take to help mitigate my current drawdown in order of severity:

1) Sell losing positions

I always sell losing positions, with the objective of no one trade being able to reduce my total equity by more than 1%.    This is nothing new, but Jason Russell over at Acorn Global Investments has created a video to demonstrate this concept in a novel way.

2) Stop using margin

I use much less margin than I did during my youth, which is a trend demonstrated by several market wizards who I consider old traders, not bold traders. 

Nonetheless, if I do use margin, it is only when the trend is strong, and the odds are firmly in my favour.  Now is not that time.

3) Reduce Position Size

A drawdown, by definition, reduces the amount of capital at my disposal.    Thanks to my position sizing formula, the less capital I have, the smaller my positions are.    This keeps my drawdown linear, while persevering the potential to grow my account exponentially.

4) Lower the percentage of my capital that I risk on each trade

I have mentioned many times in this blog the importance of limiting risk to 1% of account capital, meaning if you get stopped out, the value of your brokerage account falls by just 1%.   However, this number can be adjusted (downward only) in the event that your odds begin to move against you.

This concept was introduced to me in one of Michael Covel's best podcasts with card counter Mike Aponte and explained in more detail here. 

5) Cease adding to winning positions

Amateur traders hang on to losing trades, and pre-maturely sell winners;  professional traders cut losses short, and add to winners.   However, adding to winners works better in a rising market, and should be stopped once the general market weakens.

6) Discontinue adding new stocks to my portfolio

If the general market's trend does come to end and turns down, it is best to stop buying new stocks, as I would never want to fight the trend of the general market.     If I don't have an edge, then I stop betting.

7) Diversify in other systems and assets classes

It's important to remember that equities represent just one of many different assets classes.   If the market continues to struggle, why not deploy some capital to some completely different market, such as managed futures, fixed income, or precious metals (if they are trending higher).

8) Short sell market indices or individual stocks

Shorting individual stocks is a losing proposition on average, but when the trend is right, as it was, for example, in 2008, then shorting stocks can pay off.