I find that the world of trading is filled with paradoxes. In this post, I will discuss one of these paradoxes:
- Traders who have a high win rate appear safe, yet actually tend to be fragile and risky.
- Traders who have a low win rate appear risky, yet actually tend to be robust and safe.
We are taught in school that good grades are desirable and those with higher marks will end up achieving greater success in life. Paradoxically, in the world of trading, it's just the opposite: traders who have very high win rates are prone to failure.
For example, I have identified one money manager who has a win rate of 98.6%. This means that out of 100 trades, about 98 or 99 will be closed out at a profit. To the novice trader, he sounds like a genius, that he must have found "the secret" of trading, or "the holy grail".
In order to achieve this, the money manager does not sell a position for a loss, but instead doubles down. After averaging down, if the position is still in the red, he will average down again. This goes on indefinitely, until the position can eventually be closed out at a profit.
The problem lies in the 1% of the time where you keep averaging down, but the position does not revert to the mean and keeps on trending. You keep averaging down, over and over, until you reach the point where you run out of money and you find yourself, well, completely bankrupt.
Here is a picture of this money manager's equity curve:
The equity curve initially appears safe and steady, but contains an extreme amount of risk lurking under the surface.
The unfortunate clients of this money manager are what Nassim Nicholas Taleb would refer to as turkeys, as the following quote from his book, The Black Swan, illustrates:
I'll leave you with three quotes:
- The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.
- The equation is simple - most important is how much you win when you win, and how much you lose when you lose. Forget right or wrong.
- Any strategy that gives you a steady 1% a month is probably Bernie Madoff or Long Term Capital Management (i.e. soon to be exposed or busted).