Today, we are going to continue discussing the topic of risk reduction and what investment indicators you should pay attention to in order to preserve and increase your investment capital.
In today's article, you will find out:
1. What the maximum drawdown should be
2. How to choose the time for investment
3. About the signs of Martingale strategy and loss overstaying
4. How to use leverage
5. About possible return on the account
6. How the account reliability depends on the duration of its operation
In the previous article, we have dissected the diversification technique which allows for major risk reduction. By properly allocating the assets, we are already protected against unexpected negative events which may take place on one of the trust accounts.
Choose a manager
But then again. we can treat investment as business and thoroughly examine the projects and managed accounts which we are planning to invest in. Unfortunately, however, because of the simplicity of the procedure, investing often ends up becoming a regular game of Russian roulette: either you win or you lose.
It should be noted that investing in financial markets and investing in the real sector are essentially similar. Behind the seeming simplicity, the risks are majorly underestimated in anticipation of return on investment, and the investor turns into a gambler.
Typically, when deciding to become a stakeholder in a business project originating from the real sector, a person evaluates various factors: political environment and economic trends in the country, the sustainability of the business he or she wants to invest in, the payback period of the project, the economic and marketing aspects, risks, etc. A careful consideration is also given to the business plan.
On the flipside, when it comes to the financial markets, more often than not, the investor focuses on the percentage of return only and relies on this when making an investment decision.
But why is thorough analysis ignored in financial markets? Why do investors overlook even basic indicators, the understanding of which is essential as it can reduce the risks exponentially and improve the effectiveness of the overall investment?
Why is the investor not interested in how this profitability is ensured: thanks to increased risks, the use of unreasonably high leverage, trading without protective stop loss orders, risky amount, or overstaying positions?
In this article, we are going to examine the main indicators which will serve as a baseline for investors when choosing a successful account. A conservative approach and wish to preserve capital are the key investment principles.
Maximum drawdown size
The professional managers are essentially operators of their trading system. They have a clear set of rules and patterns they follow when trading.
As a general rule, they aren’t insiders, nor are they the forecasters which means they are trading probability. It is important to understand that since we are talking about probability trading, getting losing trades is an integral part of the business, just like the drawdowns are a natural part of system-based trading.
Drawdown is the maximum loss from a peak to a trough, before a new peak is attained.
For the investor, this is risk tolerance. 50 % historical drawdown means that when investing at maximum values, the same drawdown on the capital allocated to this account is possible in the momentum.
In case of major drawdowns, when there is an interest in a managed account which is evidenced by profitability figures, one can opt for diversification, having mathematically calculated what portion of the capital should be allocated for this.
That being said, the drawdowns which exceed 70 % are likely to result in a complete loss of the deposit by the smallest failure of the strategy.
How to choose the time for investment
Typically, the investment account is the most attractive at the highs. As previously noted, the drawdown will be a common occurrence if the trader trades probability.
So, there is obviously a chance that the manager will go even higher from the high; however, it is important to keep in mind that the odds of the drawdown increase too. The similar thing applies to the real business. You can wait until the price for product or real estate drops, or buy at current prices in hopes that the high will be updated even in case of the drawdown.
An alternate approach may be based on investing portion-wise or figures close to the natural drawdown. Not the maximum, but the natural drawdown. Just take a look at the account and check out how much the price rolls back by deposit growth.
Signs of martingale strategy and loss overstaying
It is an alarming sign when the account curve is going upwards smoothly and beautifully, sometimes even without losing trades. As already mentioned, probability trading implies getting losing trades. What is important is that the profit exceeds the losses many-fold.
When analyzing the account, keep an eye on the statistics of trades. It looks very suspicious when there are no losses at all. This may point to the fact that trades are opened without a protective stop order and they are overstayed until the profit is made.
This approach may work as long as the market is within the range (trading corridor). However, once the market is in trend state (state of directional movement), the account balance can quickly fade.
Martingale strategy also implies loss overstaying by also adding to the position as the price moves in the red, which is clearly demonstrated by increasing marginal lending. In case of the trend, this will result in even faster burst-up.
As far as the loss-free trades go, it’s safe to say that we are dealing either with a pure genius who does not make any mistakes, or with an insider. But then again it’s highly unlikely that he or she would be managing public account. Access to insider information will also provide the latter with non-public capital that is willing to participate in this affair.
How to use the leverage
It is important to understand that the greater the amount of leverage, the higher the risk of disastrous consequences in case of sudden developments in the global markets.
This occasionally happens to certain stocks (price gap). And even though this phenomenon is relatively rare when it comes to Forex, but it does exist.
Generally speaking, 20-30 leverage is believed to be reasonable enough and relatively safe. The smaller the value, the safer the managed account.
Unlike the natural drawdown where an investor can abandon an account at any time once he or she no longer sees the investment retention as feasible, the use of margin lending can result in adverse consequences in the momentum, in which case nothing can be done.
Possible return on the account
In a professional environment, the expected annual return is commonly calculated based on three maximum risks, i.e. if the maximum drawdown is 30%, the chances of achieving 90% return are high.
That being said, the figures may vary in each individual case which is why you should go from the risks and the drawdown. Protecting the capital is what’s important here.
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Account reliability depends on the duration of its operation
The longer the account exists, the more reliable it is, since the time is what puts the strategy to the test in different market conditions. The same way, it tests the manager as an administrator of the trading system, his or her stress resistance in challenging situations and in case of a drawdown.
It is recommended to consider the accounts which have existed for over six months. The older the account, the better the statistics on it, and the more you can trust it, provided that there are active trades.