It is very unlikely that you will stop trading if your system is trading profitably. However, if you are in a trading year that takes too big a loss, you are likely to stop trading, even if your system has been tested and shown to make a profit over a longer time period. Therefore, design a system based on the risk you are prepared to take which includes a budget for your drawdown.

So how does one pick the best formula for your drawdown time? I will rephrase this question. How many losses in a row should you allow for?

First, I will use the simple example of tossing a coin. If I tossed a coin and it landed "Heads Up" 10 times in a row, are you surprised? However, if I tossed the coin 800 times, your outlook on the results are different.

Trading uses the same scenario. When testing your trading system over many years, you will find a run of 10 losers or 10 winners in a row. Mathematics provides some answers to the likelihood of this happening.

See the examples given in the table below:

 -----------------------------------------------
 Probability of Losses in a Row
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 System Win/Loss Ratio	60:40 	50:50 	40:60
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 5 losses in a row 	1%	3%	8%       
 6 losses in a row 	0.4%	2%	5%       
 7 losses in a row 	0.2%	1%	3%       
 8 losses in a row 	0.1%	0.4%	2%       
 9 losses in a row	0.03%	0.2%	1%       
 10 losses in a row 	0.01%	0.1%	0.6%
 -----------------------------------------------
 

A typical trend following a system has a 50:50 win: loss ratio. That is, half of the trades are winners and half losers. This is not a problem, because winning trades will make a larger profit than losing trades will make a loss.

A 50:50 system has a 1% chance of seeing seven losses in a row. Therefore, most trend following systems should budget between five and nine losses in a row. The good news is that there is the same chance of getting between five and nine winners in a row!

I hope you see the importance of making these decisions before you begin trading. Making the proper decisions before you start is what successful trading is all about.

David Jenyns is recognized as the leading expert
when it comes to designing profitable trading
systems. His most recent course Trading Secrets
Revealed is a step-by-step trading roadmap to
having excellent money management.

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