By taking a casual stroll around typical platforms like MyFXBook or FXStat, it becomes impossible to ignore the 3 or 4-digit returns that some systems claim. Of course, these systems attract the largest amount of followers, hence giving the manager a very handsome compensation.
I believe this is one reason why regulators are starting to come down hard on Copytrading and Mirror trading: retail investors are lured into investing with these managers, without any idea of the real risk inherent in the strategy itself.
In this article we illustrate a high win-rate strategy, and will show you why these strategies are liable to blow up, sooner or later.
Our High-Win Rate System
Sometimes it may seem like we’re behind the curve. There are people delivering 100+% returns in the retail arena whereas we stick to our consistent but boring returns and advise people that 20% per year, done consistently and with contained drawdowns, puts you in the top 5% of traders worldwide.
So without further ado, here is our own high win rate trading system. The rules are simple:
- Identify a trend.
- Calculate today’s High – Today’s Low.
- Add that onto today’s close for longs; subtract it from today’s close for shorts.
- Hold the trade for 1 day.
Source: Proprietary elaboration by our programmer Tony Shacklock.
The system has:
90% win rate over 177 trades on the Euro using daily charts, and an SQN of 2.5
This is actually more impressive than it seems, because we’re using daily data instead of the usual intraday scalping that most systems use, and we are showing the R-Multiples as our equity curve which are possible simply because this system does use stop losses (whereas most high win rate systems do not).
- The red line is a take profit at 0.5 ATRs
- The blue line is the system as described above.
The question becomes: why not trade the system on real money, offer copytrading services so hundreds of people can join, then sit back and watch the profits roll in?
The Hidden Truth Behind High Win Rate Systems
To understand the answer, we need to understand how these high win-rate systems work.
Rule #1: high win rate systems always have (infrequent) large losses and (frequent) small gains. Look at these numbers:
The system is scalping for a handful of pips on average, while the disaster stop loss is around 15x the average win.
Rule #2: High win rate systems often have no stop loss at all, which makes it impossible to calculate proper risk measures for the system.
The Sharpe ratio measures the excess return over the standard deviation of returns. It is a measure of how much risk there is in a certain trading strategy. The lower the number, the higher the risk. For example, our London Open Signals have a Sharpe Ratio of 1.53. Any successful trader should have a Sharpe Ratio above 1 at least.
Rule #3: High win rate systems will survive only if the position sizes are tiny compared to the overall account (so you can trade through the big losses that occasionally happen).
Rule #4: Usually managers employ a martingale-style money management strategy to recover losses. Since they have a 90% win rate, after a loss there is a high probability of having a win. The position size on the next trade is inflated so that the usual 5 pips will recover the loss. You can actually see this in the chart above, where there are spikes in the green bars on the bottom of the picture (position size). We all know that it only takes a few consecutive losses to demolish an entire account, using this kind of strategy.
These gimmicks allow high win-rate systems to survive, sometimes for extended periods of time. But everything is probability-based and just like Long-Term Capital Management (which employed the smartest accademics in the world at the time), it is just a matter of time before the markets punish this behaviour.
Why These Systems are Fools Gold
Just as we wrote previously, systems like these are fools gold. Here’s why:
- Judging a trading system simply by it’s performance is like choosing which car to buy based on it’s top speed.
- It’s tough to see a system that has been live for more than 12 months (I do wonder how many systems work for a short period of time, attract a ton of investors, and then break down or are shut down completely after a certain period of time, leaving the manager with full pockets and the investors with empty pockets).
- Many systems are optimized.
- Many systems work only on 1 instrument (which again smells like optimization).
- Practically all systems have Sharpe Ratios below 1, and a fair share below 0.5.
- Many systems use martingale money management strategies.
Remember: it’s not how fast the car is (how steep the equity curve is) but instead it’s how far the car will take you (the manager’s longevity) and how bumpy the ride is (how contained the drawdowns are) that really matters. In this case I would also add that the kind of strategy being employed is important to know.
So why do these systems persist in the retail space anyhow?
Mainly because they attract hoards of retail traders and can be very lucrative for the managers, even if for limited periods of time. The managers usually have introducing broker agreements (and sometimes are brokers themselves!) with a series of brokers, and receive rebates each time a trade is placed. Imagine the benefits if you have 200 clients are you are receiving a fraction of the spread! If you also add the occasional profit share agreement or some other negotiation that happens between the manager and the brokers involved, you realize just how profitable these systems can be.
It’s all about short-term gain, exploiting the lack of knowledge and understanding of how these systems really work.
Over to You
Don’t fall for 45° equity curves showing 90% hit rates and constant profits. Use your common sense and know that if it looks too good to be true, it probably is too good to be true. These managers will survive so long as they are attempting to trade a broader trend within which the pullbacks remain contained. But the moment they get a runaway market (which we love, by the way), their accounts are toast.
We aren’t supertraders, but we steer traders towards robust models with good Sharpe Ratios and solid risk management. We have trained a number of talented individuals that are being scrutinized by our funding partners. We are building solid mecchanical trading models. We will be offering our own copytrading services in the near future, done properly.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals and Education from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.