Why Trading Strategies Stop Working
While some of us know that trading psychology and money management are important, it does not mean that you can go easy on your trading strategy.
We tend to think about trading strategies only when we encounter losses. It is always better to create your own strategy with guidance rather than copying others’ strategies without understanding.
Without an understanding of the logic behind the strategy, you may exit early, panic in a volatile market, or enter at the wrong time, all of which will eventually lead to losses.
To comprehend why trading strategies stopped working, we need to grasp a few concepts before creating one.
Market Conditions
We know that prices are always changing, and the market can be very volatile at times, leading to losses.
However, it does not mean that trading strategies have stopped working; rather, the market conditions have changed. So, having one or two strategies is always beneficial.
For instance, if you are a trend trader of the index, you may find ranging markets to be unprofitable or lacking opportunities. Having a similar range-bound strategy can be useful.
You can always opt for a no-trading period.
Similarly, if you are a volume trader, you might want to create strategies for a period with low volume.
Likewise, if you are an options trader with a preference for volatility, you may need to consider other options strategies, such as selling options for a non-volatile market.
So, in a nutshell, adapt to the market needs and always have a plan B.
Backtesting
Consider drawdown while backtesting your strategy. Drawdown is simply the percentage of loss you will encounter before turning a profit. It often involves consecutive losses and may be misunderstood as a strategy failure at times.
Next is curve fitting, which is simply over optimization. If you over-optimize your strategy while backtesting, it might not work as intended.
You could tweak your risk percentage, entry criteria, quantity, etc., to achieve a desired outcome, say 50%. However, that doesn’t guarantee the strategy will deliver the same profit every time.
Excessive tweaking is also risky, as you can never predict the exact market conditions you might encounter in the future. You may perceive the strategy as no longer working, but it’s the over-optimization that resulted in losses.
Demo trading before using your hard-earned cash in the real market can help you gain confidence in your strategy.
Also, when you backtest, remember the concept of the ‘law of large numbers.’
It roughly means that the results of a large number of trials are close to expected returns.
Therefore, always backtest a minimum of 100 trades to understand the percentage returns of that strategy.
This will also help you gain confidence in your strategy.
Risk Management
Another important factor is the lack of a proper risk management plan.
Even with a perfect strategy, you may incur losses due to inadequate money management.
Money management entails having a fixed risk-reward ratio and a percentage loss of capital per trade in your trading plan, which should be followed with discipline.
Strategy hopping
This is the most common reason for a failed strategy. While you might have fixed your risk management, backtesting, etc., you may be unknowingly engaging in strategy hopping.
That is, when there are one or more losses in your trades, you might conclude that the strategy stopped working.
In reality, any strategy would work only approximately 60% of the time, 10-20% less or more.
Without understanding the nature of trading strategies, you might think that the strategy stopped working and move on to the next one.
Losing consecutively in the second strategy could lead you to abandon it and move on to a third. This is called strategy hopping, and it will never work in your favor.
Stick to one strategy, have a backup for opposite market conditions, and that’s it – you are good to go.
Technology
Changes in technologies like algorithms, platform execution, market access, faster connectivity, etc., can create a perception that the fault lies with your trading strategy.
Regulatory
Changes in government rules, timings, bans, or limitations can alter the efficiency of your strategy. Therefore, tweak your strategy according to these changes.
Behavioral Shifts in Market Participants
Behavioral changes such as investor sentiments, overreaction, underreaction, herd behavior, risk aversion, and lack of emotional control can contribute to the failure of strategies.
External Factors and Global Events
External factors such as micro and macroeconomic data, global events, may influence changes in the market movement.
Learning from Failed Strategies
Regularly reviewing your trades will also help you gain confidence in your strategy.
Journal all your trades and track the reasons for both failed and successful strategies.
This practice will contribute to achieving consistent returns.
Technicals
Similar to strategy hopping, this is the most common mistake any beginner would make.
If you don’t understand the logic of your strategy and the basics of the stock market, you may mistakenly believe that your strategy has failed.
For example, if you are not aware of terms like ‘fakeout‘ or ‘stop loss hunting,’ you might attribute the opposite move to a failure in the strategy.
Therefore, it’s crucial to understand the basics and the reality first.
Conclusion
In summary, trading strategies can stop working due to frequent changes in markets influenced by technology advancements, economic shifts, and fluctuations in investor sentiments.
Traders must adapt to these changes and avoid rigid adherence to a single strategy.
While it’s crucial not to frequently change strategies, finding a balance and being smart about when to make adjustments is essential for success in the unpredictable world of trading.
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