Beginners chase profits, professionals manage risk

The most important part in maximizing the profits of your strategy is to make shure risk is under control, and that a period of drawdown won't wipe out the account.

That has been discussed more thoroughly in:

If you haven't read that article yet you might want to do it now, since this article builds on it.

Contrary to what most people initially may think, more risk and leverage does not necessarily mean more profits. Profits only increase with risk up to a certain peak and decline after that,
because drawdowns and enhanced commissions make it more difficult to pick up after a larger period of drawdown.

Also, as we saw in the first article the choice whether to used fixed lot sizes (=no reinvestment of profits), or variable lot sizes (=reinvestment of profits), depends very much on the consistency of the strategy:
  1. For a strategy which features large winners and large losers, no reinvestment will yield better results
  2. For a strategy with many small losers and larger winners, reinvestment will yield better results
Also, the profits rise with increasing risk up to a certain point (the optimal risk), and decline thereafter. We find this optimal point by using the JForex optimizer.
The value it yields, depends - of course - on the time span we chose to backtest on. You might want to include periods of reasonable drawdown.

For the current discussion, we choose to begin with Jan 1st, 2009, since the strategy would have killed the account with any money management scheme in 2007 and 2008.




As we can see, variable lot sizes aka reinvestment of profits would have fared best here, since the top 7 are all occupied by variable lot sizes. 

Note that a 4% risk setting with variable lots would have outperformed a 11% risk setting with fixed lot sizes (which means the lot size is calculated so that the stop loss being hit would take 11% of initial deposit).

As discussed in the previous article, the maximum profit is also limited by the maximum drawdown we allow. The larger the maximum drawdown, the larger possible profit to attain. In the displayed optimization we used a maximum drawdown of 30% (which is my pain threshold).

All lines grayed out in the optimization hit 30% drawdown after the displayed number of trades. Note also, that the 11% risk variable setting of the examples in the previous article yielded about 4.7 million whereas the top performer here only makes about 4 million. The larger performance comes at the price of a larger drawdown.

Another remarkable thing is how quickly profits drop, when moving away from optimal risk. As we can see as we take only 3 percentage points less risk our profits almost halve. Nevertheless we might want to take a slightly suboptimal setting to be on the safe side of the road and to provide for rainy days ahead.

This is what the equity curve of optimal risk looks like:
As we can see we end up with the four millions from the optimization, but the equity peak was about 12 million. As market conditions change, every strategy has its good and bad days, and the challenge is to find out when to run a strategy and when to have it on the sidelines. This requires more intimate understanding of how it works and also an understanding of how the market works.

So the old investment rule: "Don't invest in what you don't understand" is still a much more effective protection than any kind of money management can be.

Finally if you want to experiment with the strategy yourself in manual trading, i coded a custom JForex indicator for you, which you can download  HERE. It will show the entry signals of the strategy on the chart:




P.S.: If you appreciate this article and the indicator, don't hesitate to hit the like button!
Thanks!

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