September 9, 2007

Book notes – Way of the Turtle - III

The sixth chapter discussed various trading concepts such as support and resistance. These concepts are discussed in detail in this chapter with examples.

The seventh chapter is crucial to help answer the question: How can you know if a system or a manager is a good one. I would suggest reading this chapter in detail and understanding it and applying it when selecting or evaluating a trading system. A lot of trading systems refer only to the returns and choose to ignore risk. The chapter refers to four types of risk.

Drawdown – String of losses than can reduce capital in the trading account. It is the maximum loss the trader / manager or trading strategy incurred at any point of time.

Low returns – period of small gain where the trader cannot make enough money to make a living

Price shock – sudden price change which can wipe out a trader

System death – Change in market dynamics that causes a previously profitable system to start losing money.

The chapter discusses each type of risk in detail with examples for various trading systems. I was amazed with level of volatility which a lot the trading systems show. For example the author refers to trading systems which can generate returns of almost 35%+, but incur drawdowns of 40-45%. So there would be times when your capital would drop by 40%.

How many of us have the nerve to withstand this kind of losses?. So the next time around if some one recommends a trading strategy with high returns,ask about the drawdown. If the other guy cannot tell you the drawdown of his strategy, run (he does not know about trading or is trying to fool you). If he does give you a number, try to figure if you can tolerate that level of risk. The book also indicates that the higher the level of return, higher is the volatility and higher the drawdown. So if one is a beginner, try for a system which has a lower return and lower drawdown.

The next chapter revisits risk and money management again. The author again cautions the reader from underestimating risk and blindly accepting the claims of vendors or money managers. Curtis’s advise is to go for returns at which the risk is manageable and let compounding do its magic. No point in trying for 100% to 200% returns and then blowing up (losing all the money).

The author makes a very important point in this chapter. He says that trading is simple, but not easy. He gives the example of people like dentist or doctors who are smart and under the assumption that if they are smart and successful in their profession then they should be good at trading too. The reality is that these folks are not good traders.

I find this comment interesting. I have seen this all around me. A lot of people I meet are smart and very good at their jobs. They automatically assume that they will be good at investing. Intelligence may be a necessary but not a sufficient ingredient for success at investing. It is surprising that most professionals think that they can put 1-2 hours a week into investing and be a great investor. By that analogy, all of us should be good doctors and architects too. Anyone can be a good or great investor, but like most other pursuits in life, one has to work at it.

Coming back, the author also says that most new traders underestimate the pain of a drawdown. They believe that they can live through a 50-60% drawdown, but when it hits them, they may stop trading completely or change methods at the worst possible time. I have faced a drop of almost 25% early in my life as an investor and even that was painful. When you are starting off and face this kind of drop, it is easy to question the process.

Posts on previous chapters here and here

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