All trading, and by necessary extension pair trading, is challenging and not for the faint-hearted. Large losses or a string of losses, especially if trading at excessive size, can devastate your capital, and with it your confidence and ability to continue. It helps that pair trading is a long/short hedged strategy with lower volatility than long-only or short-only, but risks remain and large losses still occur. It’s no wonder most traders give up after a bad trade or a period of underperformance – they have not learned how to handle trading losses.
How to Handle Trading Losses with Confidence
Besides the obvious risk management techniques that will a priori substantially mitigate the risk of large trading losses (please see our previous two blog posts on Risk Management Vol 1. & Vol. 2), there is a very important element that needs to be addressed if you wish to pair trade successfully. Your trading psychology, and most importantly, how to handle trading losses.
Our short video below addresses this topic head-on, and we consider it required viewing (along with our Risk Management videos) before anyone should even contemplate trading real money with our software and system:
Here are some points to consider when dealing with the subject of how to handle trading losses.
Build Conviction in Your Trading System
Success in automated or semi-automated systematic trading demands unwavering confidence in your system. Without this conviction, poor decisions and eventual abandonment are likely. Two critical elements are backtesting and forward testing.
Backtesting:
- Description: Conduct thorough backtesting of your trading strategy using historical data. This involves running the trading system on past market data to see how it would have performed.
- Benefits: Provides a clearer understanding of how the system performs across different market conditions, helps identify any potential flaws, defines the theoretical maximum drawdown over that historical period and allows you to refine elements of the strategy for better performance.
Forward Testing:
- Description: Implement the trading system in a live market environment but with small position sizes. This is also known as “live testing” or “beta testing.” It allows the trader to experience real market conditions and see how the system performs in a live setting.
- Benefits: Helps the trader to understand the practical aspects of executing trades, dealing with slippage, and managing emotions. It also provides real-time feedback on the system’s performance without risking a significant amount of capital.
PairTrade Finder® Ultimate Alpha 3.0 is designed to easily allow you to backtest and forward test (live trade on paper or small position size) a Watchlist of up to 300 pairs or more as a way to i) chose your preferred pair candidates, ii) get used to the characteristics of the system and iii) experience in real time the challenges to trading it accurately. You can also implement scaling-in to trades, time stops and RSI entry filters into your system backtests to refine it.
The Importance of Paper Trading
One of the most effective ways to build this confidence is through paper trading. Practice without risking real money to develop your skills and build trust in your system. If you are an Interactive Brokers PRO account holder, they will provide you with a $1,000,000 balance paper trading account (not a demo account, the fills in an IB paper trading account are very close to likely real-money fills). You can use this paper trading account and Ultimate Alpha 3.0´s semi and full autotrade functions into IB Trader Workstation to run a pairs portfolio real-time on paper.
We recommend engaging in at least 100 trades and dedicating three months to paper trading before committing actual capital. When you do transition to real money, start with small trade values using risk capital—funds you can afford to lose without impacting your financial stability.
Embracing Losses as Part of Your Trading Business
Trading losses are inevitable, much like business expenses. Even legendary investors like Warren Buffett experience losses. The key is to determine whether they are within “normal” parameters or a system adjustment is necessary, and if normal then to accept them, learn, and move forward without deviating from your strategy. If abnormal, then it gives you a critical flag to revisit the system you have built for vulnerabilities.
Discover PairTrade Finder® Ultimate Alpha 3.0
For more trading insights and to enhance your trading potential, explore PTF UA3 and our comprehensive suite of educational materials. With them, you will learn more about mastering pair trading and building resilience in the market.
You can access our free webinar, start a free trial, and gain access to our acclaimed How to Successfully Pair Trade Stocks Video Training Course also for free. Just sign up here.
To Your Consistent Profitability,
The PairTrade Finder® Team
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