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Tuesday, November 12, 2013

How to reduce your maximum drawdown while increasing your profits

 

The Principal Behind the Strategy

Consider this: If you use a system with a R/R ratio of 1:1 and it’s profitable, that means the entry criteria that you use has at least a 50% chance of hitting the profit target. Suppose when you win, you gain $1 and when you lose, you lose $1. If your R/R ratio is 1:1 and your win percentage is only 50%, your system will break even (before commissions).
Now, what if when you win, you gain $1, but when you lose, you only lose $0.75? In that case, even with a 50% winning percentage, your system has a mathematical edge. If you take a total of 100 trades and 50% of them are winners, after 100 trades, you would have lost 50*0.75 = $37.5 but gained 50*1 = $50, resulting in a net profit of $12.5.
If price has an equal chance of moving x pips in your favor and x pips against you, but you win more (dollar-wise) when you are right and lose less when you are wrong, your system will be profitable. This is the basic principal behind the strategy.

How to implement the strategy?

This strategy does not require our profit target to be greater than our stop loss. Rather, it requires us to do a partial exit when we are wrong. The strategy focuses on reducing our losses when we are wrong instead of maximizing our profits when we are right.
Here’s how to implement it: Say you bought EURUSD at 1.2312, with a stop loss and take profit of 50 pips. You’ll enter two orders, one with a stop loss and profit target of 50 pips and another with a stop loss of 25 pips and a profit target of 50 pips.
Forex Money Management Strategy
If price goes against us and hit our maximum stop loss, we’ll only lose 50 + 25 = 75 pips . However, if it moves in our favor, we’ll gain 50 + 50 = 100 pips. If we assume that there’s a 50% chance of price hitting our profit target, our system will have a significant edge.

But…

Of course, there’s no free lunch in the world, especially in the financial market. One disadvantage of using a partial stop loss strategy is that on some occasions, price may go against us initially and hit our first stop loss, before reversing to hit our profit target. In that case, we’ll end up with a smaller profit than we would have if we didn’t use a partial exit. Nonetheless, even in this undesirable situation, we’ll still have a profit of 25 pips. However, if this happens regularly, we should perhaps consider revising our entry criteria.

Putting it to the test

To test if this exit strategy can indeed lead to higher profitability, I coded an Expert Advisor using a low volatility breakout strategy. Here’s where the rubber meets the road.
Entry Criteria:
Take today to be Day 1, yesterday to be Day 2, and the day before yesterday to be Day 3.
If range of Day 2 (High – Low) is greater than 10 pips, but smaller than 50% of the 14-days average true range (ATR) of Day 3,
  • Buy when price breaks above Day 2′s high by 1 pip.
  • Sell when price breaks below Day 2′s low by 1 pip.
Cancel orders if they are not triggered by the end of the day.
Stop Loss:
First Stop Loss:
For both buy and sell orders, set the first stop loss at the midpoint between the high and low of Day 2′s candle.
Second Stop Loss:
For buy orders, set second stop loss at the low of Day 2′s candle.
For sell orders, set second stop loss at the high of Day 2′s candle.
Low Volatility Breakout Sample Trade
Low Volatility Breakout Sample Trade
Note:
Since stop loss is based on Day 2′s range, and Day 2 is a low volatility day (range < 0.5*ATR), there will be some cases where the stop loss is very close to the entry price. When that happens, the order may be rejected by your broker as most brokers require stop loss to be at least a certain number of pips away from the entry price. For such cases, set stop loss to be as close to the order open price as possible. For instance, if you enter a buy stop order at 1.3213 and the previous low was 1.3205 (8 pips away), but your broker requires a minimum stop loss distance of 5 pips, set your first stop loss at 1.3208 (5 pips away) and second stop loss at 1.3205 (8 pips away).
Profit Target:
Use a R/R ratio of 1:1 (based on the second stop loss) to determine your profit target.
Results:
This strategy is profitable for all the 6 pairs (EUDUSD, GBPUSD, AUDUSD, NZDUSD, USDCHF, USDJPY) tested, but the percentage return is rather low. However, the key focus of this test is to determine if a partial stop loss strategy can indeed lead to greater profits and smaller drawdown.
As you can see from the table below, results clearly indicate that the partial stop loss exit strategy works. For the first four pairs, using this exit strategy resulted in greater profits, and more importantly, a lower drawdown. For GBPUSD and NZDUSD, the stop loss strategy resulted in slightly lower profits, but the maximum drawdown is reduced in both cases. This reduction in maximum drawdown more than compensated for the reduction in profits.
Profits and Maximum Drawdown of a Partial Stop Loss Exit Strategy
PairWith Partial Stop Loss
Profits
Max DD
Without Partial Stop Loss
Profits
Max DD
USDJPY$20823.72
21.46%
$17746.76
26.77%
AUDUSD$4462.73
29.91%
$2428.55
32.72%
EURUSD$10110.54
29.87%
$6554.3
34.94%
USDCHF$4665.39
31.68%
$1221.15
39.02%
GBPUSD$6769.66
22.89%
$6936.93
29.39%
NZDUSD$16477.03
22.30%
$17746.30
25.34%

Conclusions

In conclusion, I would say that the exit strategy ‘works as advertised’. It is indeed possible to achieve greater profits without incurring higher risk, you just have to work on a better money management strategy. I think it’s pretty amazing.
This exit strategy may not be THE BEST forex money management strategy, but it’s definitely a strategy that I’ll employ if I use a 1:1 R/R ratio. If you are currently trading with a 1:1 R/R ratio, I strongly urge you to consider this strategy. But of course, do your own backtest first to determine if it works for you.
Ok, that’s all for this post.
Thanks for reading, take care and I wish you all the best in your trading.

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