The Risk of Ruin
Losing
I back tested a gap fade strategy for the E-mini S&P 500 (What profit would have been achieved if all gaps were faded during the study period?) and
it showed that on trading day 82 your account would have stood at a loss of 72.25 points. This back
test is a good example of how a marginally winning strategy (I
believe the strategy returned an average of 2 tick per day profit
over 2 years) can show an extreme loss after 4 months of trading
and the account only returned to breakeven after 5.5 months of trading.
Once you have back tested a trading system do the following.
Select the period with the largest draw down and start your
simulation account at the beginning of that series. When the draw
down reaches its maximum sit back and look at the amount of money
(or percent) that has been lost and the time period over which you
have traded it and ask yourself how you would emotionally feel at
that point.
Consider the Gap Fade strategy that I did in the E-mini S&P
500. After trading this strategy for 4 straight months,
starting with $10,000 and trading 1 contract per trade, you account
is close to a 40% draw down. What do you feel at that point?
Obviously devastated. Do you have the mental and emotional resolve
to continue trading that particular strategy?
It's very important that you back test you strategy over a
sufficiently large sample of data and see what the worst starting
case scenario has been in the past and you tell yourself that it
IS possible that after 4 months of trading your account could
have lost 40% of its capital and that this is a reality.
To return the the title question in this article (How long will
it take to turn $5,000 into $0?) the answer is about 4 months
trading the gap fade strategy if you start at the wrong time.
Granted there would still be $1,387 left in the account but that's
not much of a capital base to work from. Still we're looking at
around a 70% loss in the account at that point.
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