Most beginner traders don't realize just how variable the p&l of even a very high-performing trading strategy is.
I simulated 10 5 year GBM processes with annual return 20% / annual vol 10%.
(Simulating a strategy within known Sharpe 2 characteristics.)
I simulated 10 5 year GBM processes with annual return 20% / annual vol 10%.
(Simulating a strategy within known Sharpe 2 characteristics.)
I plotted the path with the highest ending equity (green), median (black) and lowest (red).
All paths are from exactly the same process, with the same known return distribution.
You might think of the green line as trading a strategy with a known large edge and being lucky.
All paths are from exactly the same process, with the same known return distribution.
You might think of the green line as trading a strategy with a known large edge and being lucky.
You might think of the red line as trading a strategy with a known large edge and being unlucky.
Even when you were really lucky, you were underwater for 130 days.
When you were unlucky, you were underwater for 508 days (about 2 years)
Even when you were really lucky, you were underwater for 130 days.
When you were unlucky, you were underwater for 508 days (about 2 years)
You have a strategy with a *known* Sharpe 2 edge, and you might reasonably be underwater for at least 2 years if your luck falls in the bottom decile.
The reality of trading is even more uncertain because you never *know* what your edge is, see:
The reality of trading is even more uncertain because you never *know* what your edge is, see:
https://twitter.com/therobotjames/status/1372412020230787074?s=20
This is why we diversify across return sources/strategies/alphas.
It's not just for the well-understood vol-reducing diversification benefits.
It's also because, by spreading our bets, *we decrease, the chance that we are trading without an edge*.
It's not just for the well-understood vol-reducing diversification benefits.
It's also because, by spreading our bets, *we decrease, the chance that we are trading without an edge*.
If you are serious about this game, you need to understand this dynamic deeply.
And structure your life, income, expenses so this level of trading p&l variance is appropriate.
The "carry" of a salary, consulting work, or side gig is often helpful here.
And structure your life, income, expenses so this level of trading p&l variance is appropriate.
The "carry" of a salary, consulting work, or side gig is often helpful here.
And, of course, management fees.
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