The past four years have been incredible for US stocks with the S&P 500 up more than 60%. If we could go back in time to March, 2010 and I gave you the option to 1. buy and hold SPY for four years with you knowing the S&P 500 was about to enjoy a fantastic bull run or 2. trade a strategy that shorts US stocks, will have a string of eight consecutive losses, will have a 20% drawdown, loses on 35% of the trades and will have four trades that each lose over 50%, which strategy would you choose? Very few traders can stomach the psychological challenges of the drawdown (especially when the broad market is rising), shorting stocks while the broad market is rising over 20%/year, eight consecutive losses and trades that individually lose over 50%.
Following is the equity curve for a short strategy that I am working on and it suffered all the negative performance attributes mentioned above.
The short strategy is based on a 5-stock portfolio and trades US stocks that are priced over $5 and have an average daily trading volume in excess of 500,000 shares. This is a backtest and must, therefore, be taken with suspicion about its performance going forward. Nonetheless, my point is that it is possible to have a strategy that provides an overall return that most traders find acceptable yet there are granular aspects of the trades that some may not be able to cope with.
Traders who can’t accept what some may perceive as failure will never enjoy success. Drawdowns, consecutive losses and losing trades will all be a part of a successful trading system. Of course, the system must have a positive expectation with an acceptable drawdown. For the system discussed here, the Monte Carlo annual average return is 33.8% and the Monte Carlo drawdown is 21.8%.