Line Your Own Pockets

Michael: 00:00

Hey, everyone. Welcome to another episode of Line Your Own Pockets. We're talking about the the big d today, the the scariest word in, all of systematic trading, and that's that's drawdowns. And, you know, happens to all of us. It's never fun when it does.

Michael: 00:15

We're gonna talk a little bit about kind of why that is and and, you know, maybe some ways to to deal with it at least mentally and, maybe some things to do to prepare. I think it's gonna be Dave thinks it's gonna be two episodes. I think it might be three or four, but but we'll see. But you got a story to to get us started with there?

Dave: 00:35

Yeah. So, I mean, I've talked about the biggest drawdown I ever had probably it's probably ten years ago now. And, you know, if you were to look at my equity curve, it would show up as a blip. Mhmm. Right?

Dave: 00:55

You would in hindsight, you're like, okay. What what was the big deal? But when you're in the moment, I get to existential thing. Like, it feels so terrible. It feels awful.

Dave: 01:10

And it's not just because of the money. I mean, that's obviously part of it and that's what's kinda causing it, but it's it's way more than that. And so I think when traders get into this and they think about what drawdowns might be or what what they'll feel like, I think it's useful to know that they're gonna be harder than you think they are. And it's more than the money. The money obviously is what shows up on the equity curve as the money going out of your account.

Dave: 01:51

But it's way deeper than that. And I think I think it boils down to, this plan I had that I thought was good, turns out it might not even be a plan at all. It might completely suck, and I don't really know.

Michael: 02:08

And I think there there's a couple things that really impact it. One is I think the first one is and the most important is probably where is the drawdown happening in the length of your career as a trader? So, like, if you've just started systematic trading and then you go through a lengthy drawdown in, the first month, that feels way worse than if you're five years into systematic trading and then the drawdown kinda starts because you don't know that it's come a more normal thing, I guess. Like, you just started making money, then you gave most, if not all the money right back. That's different from, okay, I've I've made a $100, and I'm giving $20 back, I think is a little bit.

Michael: 02:54

But, yeah, that's the it's the feeling I always give of a drawdown. It's it's like the whole dark tunnel where you can't see the light because you just don't know when you enter a drawdown, you never know how long or kinda how deep it will be. And I think that's more that's a worse feeling for me anyway than the drawdown itself. Like, I would be okay if someone said, listen, you're gonna go into a 20% drawdown, but don't worry. In six months if if they could just reassure you, don't worry.

Michael: 03:25

In six months, you'll be back to equity highs and everything will be fantastic. I think, like, everybody would be able to do that. Right? It's like if you're doing something horrible and you know that that horrible thing is gonna be over soon, like, okay. That's fine.

Michael: 03:37

I think the the real thing is when you're in a drawdown, it's the not knowing the the length of it. Is this a permanent thing? Right? Is my strategy just useless now? Or is this just kind of a blip on the way out?

Michael: 03:51

So I think it's more of like an uncertainty that really kinda gets everybody.

Dave: 03:55

Yeah. I think that's totally true. And the real thing is, like you said, you don't really know. Like, the the drawdowns could last forever.

Michael: 04:07

Mhmm.

Dave: 04:07

You don't really know. And I'm not sure. I understand what you're saying about the the the trade win in the first month having a drawdown. But I think it's I think it's even harder for somebody that's trading longer.

Michael: 04:25

Really?

Dave: 04:26

Because there's been enough time for you to really become a trader. Like, this is your identity.

Michael: 04:37

Mhmm.

Dave: 04:38

And that that's really the hard part of being in a drawdown where you're not sure where it's where you when you're gonna come out of it or if you will, is that your identity is at risk. And that's a very that's an I mean, that is a dangerous thing to have happen. And and like I've said many times before, the only you know, the no no trader has ever quit at equity highs. They're always in a drawdown when they're quitting. Right?

Dave: 05:07

So they're you need to be thinking about your mindset during a drawdown. It's it's a dangerous situation to be in because a lot of traders quit during drawdowns just because they lose faith. There's, like, an existential crisis. So they're very they're more dangerous than most traders think. Even, you know and I think it might even be worse deeper into your career.

Michael: 05:33

I think and we talked about this a little bit when we talked about our the multiple strategy thing. Maybe for me, I'm saying that because I guess I just have the confidence that with enough time, if I had to just stop doing everything that I'm doing right now, all, like, 10 strategies because they all stopped working, I could sit in cash and and survive long enough and then build something and then have that a little bit differently. I think it might be a little bit more depending on how niche, I guess, your your mentality is. And this I feel like I'm picking on these people because we mentioned them so much, but I just I see more and more across Twitter people going the second the pattern day trader rule went away that, you know, these guys that short these low flow penny stocks, that's all they do, and they've made a ton of money doing it. And that game seems to have, based off of what I'm reading from them, either become insanely harder or just, like, not profitable for them at all.

Michael: 06:37

I feel like I I hear a lot of that kind of quitting, you know, massive drawdown, what I did. I think, like, what you mentioned with identities, it dependent what that identity is. You know, if your identity is I'm a trader, I trade instruments, that's fine. If your identity is I'm a day trader and I'm only a day trader, well, that could be at threat if, you know, something happens that makes day trading prohibitively harder. And and more like, the more niche you go with your identity as a trader, I think the harder this becomes for you.

Michael: 07:11

Because for me, I just look at it I'll I'll trade NFTs. I'll trade pictures of rocks. If I can find a strategy that that I can prove has some sort of edge and it's got, like, a chart behind it, then I'm good to go. But, yeah, I think the more the more niche that is, I think it might be the hardest because you just expect the thing that you've done that's made you so much money to continue to make you so much money.

Dave: 07:32

Yeah. Mean, certainly, the fewer straight strategies you have, drawdowns are even worse. And so the the more strategies you have, the the the less your identity is tied up in any one strategy. And it it's such a good feeling to go from one to multiple strategies or more than one strategy and to see because you can recognize the days at the end of the day where one strategy lost money and the other one made up for it, so you end up flat. And you're like, okay.

Dave: 08:09

This is the kind of day that I would have been a a big time red, and I'm not here. So to see that play out like that is very gratifying. And, you know, multiple that by multiple strategies, and you get it's it's it's everything just gets easier, but it is hard to get there. So and when you're in a drawdown, it's I don't know. Existential crisis is the only way I can sort of describe it.

Dave: 08:42

Mhmm. So thing is, like, you're you're not thinking rationally when you're in this situation. Yeah. And and that's really probably the hardest part is that and that's when, like, somebody from the outside can actually help you because you're not thinking rationally. And you're gonna it's such an emotional like, emotional is not even the right word.

Dave: 09:10

It's like existential. So you're not gonna be thinking correctly. You're gonna make the wrong sizing decisions. Mhmm. You're gonna be you're not gonna wanna size down, but you should.

Dave: 09:23

So there's just there's just so it's so difficult. And because of there's all this wrapped up in it. But and and the problem is you're not gonna be thinking rationally. That is your your mindset is gonna be terrible for making good decisions.

Michael: 09:44

So right. Well, I guess the first I was gonna say, well, how do we deal with it? We'll get there in a second. But I think the first thing is just when do you like, drawdowns happen all the time. Like, most people don't spend every day at equity all time highs.

Michael: 10:02

Right? So, you know, drawdown, I guess we should really define doesn't mean, you know, you lost a day or two days in a row. Right? Because that everyone would call that a drawdown all the time. Right?

Michael: 10:13

It's so we're talking are you talking drawdowns on a percentage basis or or a length of time basis or, you know, compared to what you expect basis? Because it's gonna be different for for everyone. As a as a swing trader, I know that my drawdowns are gonna last longer than somebody who's who's more of a day trader because I'm flipping them out less often. Also means my winning streaks are gonna last longer than, than a day trader's winning streak. So, you know, when you really think of a drawdown that kind of really affects people, where do you kind of peg the peg that in as this is the time where I I normally start to see people starting to worry?

Dave: 10:56

Well, I think it's different for everybody. There's so many factors that go into that. Mhmm. The the way you think about risk, your, you know, your your upbringing, the way you think about money, the whether you need the money that you're trading or not.

Michael: 11:15

That's and that's huge. I think I think that might be the the biggest part of it. Right? I think someone who has a lot of money, like, right now, a bunch of income sources, they're gonna care way less. And it's funny because it's gonna probably be way better for them in the long run because they're gonna continue to think rationally.

Michael: 11:36

They're gonna be able to stick with the system for the long run first versus the guy who's like, man, I I have like a month or two to start making money or or the kids don't eat. That guy is just he's done. Right? There's there's I there's almost no way back from from something like that.

Dave: 11:51

Yeah. You just wanna avoid the situation where there's really a lot of pressure. And and I felt, you know, there were multiple times over my career where I wanted to trade full time. I almost decided to trade full time. And I felt like I had such an advantage not having to do that.

Dave: 12:20

Mhmm. And I was having so much fun in my regular work. I mean, trade ideas was so much fun. And to so to do this on the side, it was like, man, that's such an advantage I had. Like, I literally didn't need the money.

Dave: 12:35

It was like a game.

Michael: 12:37

Yep.

Dave: 12:37

And so the drawdowns I even think that the drawdowns I was probably too used to drawdowns. I I was probably I probably let them go deeper than I should have before I took some action because I didn't need the money. So I think looking back, I don't know. I I would probably have it play out the exact same way, but I do recognize that I there were times where I let drawdowns go too far. It was almost like a badge of honor, kind of.

Michael: 13:17

And

Dave: 13:20

thinking back, I could have been a lot better by doing something different. I mean, hindsight's twentytwenty. But yeah, I think there was a period there where I was, I I would say, too accustomed, like, too tolerant of drawdowns.

Michael: 13:36

One so I think we already then mentioned the first kinda way to deal with drawdowns, right, is to make sure that you, you look at probably, you know, the the thing that I've been told, and I think maybe even Marcin said this when when he was on the podcast with us, that you look at whatever the max drawdown of your system is and you kind of double it. And you say, you know, you know, can I can I deal with that? I would also probably add to that, look at the max time of the drawdown from equity peak to equity peak. Probably double that too. And say, you know, sit down and really have a hard conversation with yourself and say, if I was doing this thing full time, if this was my only income, could I could I deal with that?

Michael: 14:25

Could I be, financially okay and therefore mentally okay, to continue to do the correct thing, you know, assuming I double both those? So if your system, you know, has, a 15% max drawdown, well, and it lasted six months, say, well, could you be down 30% and in a year and still come in every day and and hit the button and let the robot do the thing and not, you know, be in there messing with things and and doing whatever? Because if not and could, you know, do the kids get fed and all of that? Because if not, then you have to either you have to have something. It has to be a secondary kind of thing.

Michael: 15:05

Right? It can't be your your primary thing, or there's just no shot that you're you're making it work.

Dave: 15:11

Yeah. Sometimes I I just had a conversation recently with a trader who came to me and said, I I I really think I could do this. I wanna do this full time. What do you think? And this is another is another case of where I often burst people's bubble, where I'm saying, hey.

Dave: 15:37

You probably shouldn't. And that there's an advantage. I mean, you have such an advantage not needing the money. Mhmm. So when you're in that situation, you have a real job, and you can carve out time to trade, and you're doing well, it's an advantage to be able to do that because, I mean, there's so many reasons it is because you don't need the money.

Dave: 16:00

But, also, it forces you into a situation where you can't do everything. You can't trade everything. So you're forced to really focus on the thing that really moves the needle for you in your trading. And as of so many times, you could go you wanna be going a mile deep and an inch wide rather than a mile wide and an inch deep.

Michael: 16:23

Well and also, I think it it forces automation too, which is because eventually, I think people and I don't know why people they'll sit in the, like, I really hate this corporate job that I have to sit here and stare at a computer all day and blah blah. And then you go, okay. We'll go trade for a living. And then they sit there and they stare at a computer all day with, you know, way less security and way more stress and way more whatever. But if you are if you're looking at it and saying in years from now, hopefully, I'll have enough money in which I can I can do this full time, and I can feel better about it?

Michael: 16:58

But now I have to do the trading while I do the corporate job or, I don't know, plumbing or, you know, whatever it is that you do, it forces you to think in that kind of automated terms. Like, I can't physically stare at the charts all day long and make discretionary decisions and and watch for, you know, really unique events in order to take trades. I have to think of it as what can I automate away? What can I systematize? What can be and then the beauty of that is that eventually down the road, if you get to the point where you do do a full time, you are you're not doing just the same thing with more risk and potentially less money and more stress.

Michael: 17:42

You have achieved that freedom of, okay, now I have a process, and that process only took me, you know, half hour a day. Well, I can continue to do that process, and now I have the rest of the day to to live life and and have a good time, as opposed to I've just seen so many you know, you ask people, you know, why do you trade? And like, oh, I want freedom. And then you they're sitting in front of, like, 17 monitors. Right?

Michael: 18:07

And they're there at six in the morning, and then they're still there at six, seven at night. I'm like, well, you don't have with no vacation pay and no right? It's like you you have you have built yourself less freedom than, right, if you had if you had done the other thing. So, you know, there's part of that as well, I think really forcing yourself to focus really makes you lean on technology and I think really opens you up to systematic trading better than just, you know, someone who who has all the time in the world, and they feel like they have to to fill with trading.

Dave: 18:40

Yeah. I like what you're saying about the length of the drawdowns, the depth of the drawdowns, and thinking about that. Mhmm. I think that it's always better to preplan what you're gonna do. Because like like I said, you're gonna be in this situation in this mindset where you're not rationally thinking.

Dave: 19:01

And the more money that's at risk, the the potentially, the worse your mindset's gonna be. Mhmm. So if you can have a plan ahead of time that says, okay. If I'm at equity highs, here's how I'm gonna do the sizing. If I'm in a drawdown, I'm gonna do the sizing in this way.

Dave: 19:23

So it becomes this preplanned programmatic plan that you're executing that is gonna save you it's gonna be a lot better situation than having to make these these quick decisions when you're in the opposite mindset to be able to do that productively.

Michael: 19:43

Mhmm. And and, yeah, I think even more than even more than the financial aspect, which we've been kinda talking with the whole time, is that emotional aspect where often the correct thing to do is is gonna be nothing. Right? If if if the drawdown is just part of normal, you know, the system and and randomness inside the system, it gets, you know, very hard to to do nothing. And that's, you know, what I was gonna ask with you for tips of because I've had people come to me all the time and say, listen, I'm in a drawdown and I I don't know what to do to to save the system or whatever.

Michael: 20:26

And I have them send over just their backtest results. And you look at the drawdown curve and you compare that to the drawdown curve of the backtest, you're like, this is just this is normal shit. This is gonna just happen. You know, you're just in a series of bad luck. And I think, for the people who are gonna do this for a quote, unquote, living or or, you know, they're going after it, they're probably gonna be very, you know, like workaholic type, you know, type a type people.

Michael: 20:54

And to tell those people their best option is to do nothing and just sit there and and just let numbers play out, I think that's that's way harder than even, you know, coming up with plans and tweaking things and and doing all that. Because the amount of times I've seen people jump from a system that was just experiencing a normal drawdown, and then they go back and look at the system later. And just like, you know, just like panicking out of a stock at the very lows, they panicked out of their system at the very lows. And that was the time that, you know, the if anything, they should have been pursuing that edge even harder because that's the moment. And we could go back to the people shorting low float penny stocks.

Michael: 21:37

Like, yeah, it sucks if that's the only thing you do, but eventually, once they flush all you guys out, you know, you fast forward a year or two, there'll probably be a whole resurgence of this thing. And, you know, the edge will just come right back because a lot of these edges are circular. Once everybody starts looking at something, that edge vanishes and then nobody trades that edge anymore because it doesn't exist anymore and then just re pops back up. It's like they're, I don't know, they're fads or trends sometimes that I've I've noticed with some of these.

Dave: 22:09

Yeah. Well, you know, the other thing to think about is the the drawdown and the depth of the drawdown is caused a lot of times by how quickly somebody has sized up. And like you said, that the person that where where you looked at the backtest and you looked at the the live drawdown and there's not that much there, probably because they sized up too quickly. Yeah. You see that I mean, that that does seem to be the default a default trader mistake.

Dave: 22:44

People tend to size up more quickly than they should. And that's because you you don't want a situation where a normal sequence of events, a normal set of losing trades spooks you out because all of a sudden you're negative or like, wow, this is a big chunk out of our equity curve. And if you've sized up too quickly, you're you're vulnerable to this. And that's why you should have a plan, like have a good plan for sizing up less quickly than you think you should precisely for this reason, because these drawdowns are so dangerous because and it's not just that the you know, your account's gonna go to zero. It's like just it's they're dangerous because they're the points at which traders quit.

Michael: 23:36

Yeah.

Dave: 23:36

They give up on what they're doing.

Michael: 23:38

Well and and, yeah, not even maybe not even quit as a trader entirely, but maybe just quit that particular system. Yeah. And, you know, then all of a sudden, they're looking back and the system turns positive again. And they're like, oh, great. Now I should jump back into the system.

Michael: 23:53

Then they're so they're riding the wave opposite. Right? They're they're chasing. It's like I've I forget what book I was reading, and it was talking about how people were using moving averages on their equity curves to determine, like, when to trade. And I'm like, that to me would create the exact opposite response that you would want in which you are you are sizing up into a strategy when the strategy is doing well, but after a period of time of the strategy doing well.

Michael: 24:25

That to me just seems like the exact opposite because you are probably in a in a situation where you are less likely that that will continue. And then as opposed to and then jumping out of a strategy when it's in a drawdown, just always seems like buying a stock high and then, right, just selling it again when it's low and just doing that over and over again. Whereas you should probably be doing the opposite. You should be saying, oh, you know, if this strategy is experiencing a drawdown and a normal drawdown, maybe it's not I'm gonna size up because it's in a drawdown, but it's maybe I should be spending more attention to that. And is there a situation where that whatever is occurring in the market to cause this is going to change soon?

Michael: 25:08

And then, like, for me, it's more of, you know, correlation of the S and P 500. Right? So, like, during the tariff tantrum, right, everything was in a drawdown. If I had jumped out there, there was, like, one day where dude had you know, that one day the market was up, like, 10% in a single day. If I had cut out of all my systems because they were in a drawdown, I probably would have been getting back after that day.

Michael: 25:33

And then the difference, you know, that one day made all the the returns or all the drawdowns back and some. So it's like you can jump out at just the exact wrong moment when things kind of look the bleakest, and that ended up being like, 2025 was an amazing year, but only because I was able to stick during that that period of time.

Dave: 25:54

Yeah. I wonder I wonder if it's there's differences with swing trading and day trading with in regards to these drawdowns in making those decisions because, yeah, I mean, the the the way I would think about sizing up or down so you wouldn't want to size down at all equity highs and size up at all drawdowns. Right? You would definitely not wanna do that. Mhmm.

Dave: 26:24

But you wouldn't wanna size up at every equity high. So you need to have some programmatic way to do it or some systematic way to do it. And I would say so there's one one trader I work with that does this really well, And he's he resizes he re redoes his sizing every day.

Michael: 26:51

Yes.

Dave: 26:51

And it's based on Yeah. A programmatic way that he's gone through and and analyze this on the back test and say, okay. Here's what I would do how it would show up in this system. And he's got multiple systems that combine so he's got a whole portfolio sizing level that he does Mhmm. And then per system.

Dave: 27:12

And it's all systematic. He's thought through all this. He's gone and tested different scenarios across time and his backtest and his live trading. And if he doesn't do anything, it just happens automatically. So Yep.

Dave: 27:30

It's a really smart way to do it, and he avoids the situations where you're gonna make an emotional decision that's like like you said, if you'd have missed that one day, that would have been a huge chunk of 2025 or whatever it was. Mhmm.

Michael: 27:46

Yeah. When I I I think that's the right way to do it. It's kind of I think we already did a a podcast on it, but the two ways that make the most sense to me, and this is, I guess, we're kind of speaking to the person in the drawdown, is the most common one I think you hear all the time is just the percentage equity. Right? So, like, I'm gonna risk half a percent of whatever my account is at any given time, and then recalculate that frequently.

Michael: 28:13

And that's likely something like that that gentleman does because then just every kind of by default and naturally when drawdowns are occurring, you're sizing down ever so slightly, and you're sizing up ever so slightly. I like that way better than doing it in chunks because you you don't have to do it in chunks anymore. You can do it based slow the amount because it should be all programmatic anyway. Should just look at the you know, you're filling in one number in a spreadsheet if you're more discretionary, or it's just getting pulled automatically. This is your account value, and then this is the amount you take.

Michael: 28:50

And then also for people I know in swing trading stuff, sometimes it's just easier to take your account and just split it up. Right? You know, if you if you have a $150,000 account and you're you know, you take 15 trades is the maximum that you'll you'll take or 15 positions at once, you say, alright. I'm gonna put $10 per position. And then you fast forward a couple years, and hopefully, that account's worth 300,000, and now you're taking 30,000 for per position.

Michael: 29:15

But it's all happening so slowly and so granularly that there's just a natural things are going well. I'm slowly kinda sizing up with it. And, now there's a little bit of a pullback. Let me slowly size down with it as opposed to, you know, your your I risk a thousand dollars per trade. And then you have to manually make the decision to, okay, now I should only risk, like, 750 per trade or 500 per trade.

Michael: 29:41

So whatever way I think, regardless of how you do it, whatever, if that's something that you can completely programatize, I think that's one of the biggest things you can do, because then you don't have you're not forced to make the decision when it's hardest to make the decision. Super easy to decide to size up when things are going well. Like, that's the easy part saying, oh, yeah, I'm doing I'm on fire. Let me size up. To size down, especially in a drawdown, that is the hardest decision.

Michael: 30:10

That's why I like these percentage of just looking at your equity. And for you guys in in prop firms, I remember when I was working back in the day at a prop firm, it was done the your max, like, stop out per day, like the the level that they would shut you down per day, that was done based off of just historical p and l. It was just a math equation for the firm I worked in the background. And every day, you'd sit down, and it was always, like, some weird ass number. Like, you can lose $532.11 today before we'll stop you out.

Michael: 30:44

And then because it would just take, I think it was your last like twenty days of trading action and like average out your P and L there, and then that was the number that you could lose any day. So, yeah, this was in 2006, 2007, they were doing this. And so it's it's a very common way to do it. And again, it just means that as people were going through drawdowns, that amount was just shrinking to the guy who maybe was risking $23 a day is now only able to risk $2,300 a day. And he knows the way to get to that risk amount again is to size back and to, you know, continue to trade and then kind of work his way back up.

Dave: 31:23

Yeah. So the the other interesting thing that this guy does is he knows one of his priorities is that some of his systems are it seems like all of his systems or all of them in aggregate. They'll go through a period of drawdown, but then they quickly come out of it. So one of his priorities is in his algorithm is to get back to full size quickly, like, more quickly than you're coming down. Mhmm.

Dave: 31:55

So I thought that was a very interesting way to do it, and it it seems to work really well for him. Because you get in this situation where you size down, and then all the of course, all of a sudden

Michael: 32:08

Everything starts working in.

Dave: 32:10

Days of your system. Right? So, so to to avoid that and to sort of programmatically get back to full size quickly, that's what he does, which I thought was a really good good approach.

Michael: 32:23

So well, talking about the sizing. So say someone is adverse to to kinda what we just went about and and programmatically doing it. How do you I think like, how do you deal with the confidence of that? So I'm I'm grateful that I use the percentage of my account, and I I just that's all sorted for me. I never have to think about position sizing.

Michael: 32:46

So I'm kind of trying to put myself back there a little bit. Because you're right, the or the gentleman who does it getting back to full size quickly is hugely important. But I could imagine a level where if you hadn't preplanned that, the confidence gets really, really hard. Where, you know, especially if the drawdown is prolonged. So say say even it wasn't that big of a drawdown, say you're okay with like a 30% drawdown, this was only like a 10% drawdown, but it lasted months.

Michael: 33:15

So you've just been, you know, the whole death by a thousand cuts for months and months and months, and then things start firing off again. I just don't know how you come if you're not doing it programmatically, how you come out of that mentally, because you're just so used to losing for so long that, you know, winning doesn't feel natural again. It's like the the whole path to confidence thing that you always talk about where it's like, how do you regain that? Okay, yes, things are firing. Because I could see a world where somebody conservative sizes down relatively quickly, but doesn't size back up quickly enough.

Michael: 33:53

So, you know, they're always behind the curve, and they're not hitting that full size at that right moment that they need in order to to make back all the losses.

Dave: 34:04

Yeah. I think it's so different for traders because, like, I don't I I don't size my position based on my account and and recompound every day because the number would be too big. Like, I I I and that I like you kinda have to I feel like you you have to kinda gradually go through these bands where, like, a certain level of r would lose a certain amount of money. I I think just going by the account size, I think I think would feel too fast to me. I know that, like and we've talked about we did a whole episode on position sizing.

Dave: 34:47

We talked about Kelly Criterion.

Michael: 34:49

Mhmm.

Dave: 34:49

Kelly Criterion is super fast. Yes. Like, you would be going you would be going very quickly to numbers that you wouldn't be calibrated to be enduring. Wouldn't you say?

Michael: 35:04

Yeah. I don't think anyone uses full Kelly. I think you'd be but even even if you're using a fractional of Kelly, you're right, it would size up. It would size up too quickly, which is one of the reasons why I almost am a proponent of doing it daily. That's why I really liked when you said the guy did it daily because supposedly, there shouldn't be that big of an impact to it.

Michael: 35:28

And if you are trading systematically, your position size should be calculated by a robot anyway. Right? You're not in there actually saying I need to take this many shares. So doing it in, you know, the smallest granular time frame, hell, if you could do it intraday, there's a period of time where you went to CAD, I would say do that as well because now we're talking about the whole, like, boiling the frog alive type of thing in which you're you're just doing it so incrementally that you shouldn't even really notice a difference. Now I could see doing it incrementally with a cap because, yeah, maybe you are you you hit a wicked trade out of the water, and all of a sudden your account's 10% bigger than it was yesterday, and you go, oh, shit.

Michael: 36:13

Am I really gonna be okay with risking 10% more on on all of my given trades? So I could definitely see that where it's like, okay, you've made a significant gain very, very quickly. And so instead of doing, you know, the the full instead of going from, you know, a thousand dollars to $1,500 on a trade, you just put a cap and you say, okay, can only grow x amount per day. But then I also worry, are you leaving money on the table at that point? Because maybe you've just hit a stride where that strategy is just really it's a high volatility strategy and the markets become high volatility for a short period of time, and you are leaving some on the table by not doing it.

Dave: 36:49

Yeah. I think I mean, just this conversation here should show people that it's really complicated. When you when you do a back test and you're like, okay. This this game's gonna be easy. Right?

Dave: 37:05

The the the decisions to make around sizing are super difficult. And it's not easy. And it gets harder. And there are even people that I mean, I work with traders that have been trading for twenty years, and they still have issues with this around sizing. Mental things, emotional things.

Dave: 37:27

So the more you can think about this and the more you can kinda preplan is is is just gonna be good for you. Now to to sort of sum up here, I think, one way like, if you if you were naively to go back and look at my equity curve over time and look at these drawdowns, you might think that the drawdowns caused all the profit. Right? Because they come at inflection points.

Michael: 37:59

Mhmm.

Dave: 37:59

And I think if if you let them, these drawdowns are can be inflection points, and they really can literally make you better as a trader if you handle them properly. So I think I I'd like to do the next episode on concrete things you can do during a drawdown to feel productive. I'm a a big part of why drawdown sucks so much is you don't know how long they're gonna last. But even if you kinda have a plan for getting out of it, it still takes time to get out of it for the, like, just the trades to come in and for them to play out. So it feels like it it you wanna have a plan for doing something productive in a drawdown when your mindset is not good to be making real big decisions.

Dave: 38:55

So there's some things you can do during a drawdown to feel productive, to make real progress with your strategy as you're waiting to come out of it.

Michael: 39:06

Yeah. And I think a good exercise for people to do is because, you know, so two things I wanna talk about. One is you can tell that position sizing is is probably pretty much everything when it comes in drawdowns. Because it's what we spent the whole podcast kind of talking about. It wasn't, you know, should you go change your strategy optimization or any of that.

Michael: 39:31

It was just how do you size yourself in a drawdown because that is that is a difference between kind of wiping yourself out and it being kind of a drawdown that is that is recoverable from. Because, yes, there's there's our worlds where edges are just disappear and they're gone, and then you have to kinda deal with them. But I'd say that is rare than, you know, you are coming into a drawdown that might even be an unusual drawdown, but it's just a it's a normal fluctuation in the system anyway, and you need to size it. So that's that's one. And then, you know, that should be you talked about going, you know, really deep on a strategy.

Michael: 40:12

Right? Going really, really deep into into a strategy. That's another way that I think a lot of traders don't really explore that could help with that. You should test kind of everything that we've talked about in a strategy where so what happens if you size on a I'm gonna risk percentage of my account, and you update that daily, or weekly, or monthly? Or what happens if you just say, okay, this system can take 10 trades, I'm gonna put one tenth of my account in it, And just go in and run those.

Michael: 40:41

Those are very easy changes to make with inside of a backtest to see what the what the difference results are. Because I've seen it and I've done it where you've taken good strategies and you just you just tweak the position size slightly and they completely fall apart. And then the other way around where you take, you know, mediocre strategies and you come up with some sort of position sizing kind of calculation that that dynamically changes over time, and those strategies become fantastic. So that would be that would be where I would be spending a lot. If I was in a drawdown, if I had one strategy, and I was in a drawdown at that time, I think that's where I'd be putting a lot of my focus and going back and and just testing scenarios to say, okay, when do I size down and when do I size back up?

Michael: 41:27

Assuming that I have faith and confidence that my strategy will start to perform again and still has an edge that I'm that I'm exploiting, it would be that that would be the only question I'd be focusing on is when do I quickly get back to full size without doing it so early that I can I can blow up, but doing it not so late that I don't quickly recover my losses and start start making money?

Dave: 41:52

Yeah. Well, I can think of different ways to yeah. I think we're I think we're gonna come at this from different angles next time when we when we talk about this.

Michael: 42:05

Well, that'll be interest I see. Told you it'd be a bunch because, yeah, it it's you know, getting to the root of the problem is just the first the first step. Right? And, again, we're doing all of this assuming that you didn't have some really kind of niche edge that just vanished one day. That's a completely different problem.

Michael: 42:21

We're talking about deal

Dave: 42:22

That's easy.

Michael: 42:22

Yeah. Yeah. You just you have to if you've determined that's the case, you just need another strategy. Right? That's that's a simple, side of things.

Michael: 42:31

But we're saying what if, yeah, you're in this normal drawdown, how do you mentally deal with it, which I think is just is huge. So looks like Dave's got some answers. I might have some different answers and good. We I was gonna say we just we had our hundredth episode. That was all fun laughs and joys.

Michael: 42:47

So it's time that we pull up the knives and see if we have

Dave: 42:50

Yeah. We might disagree next week.

Michael: 42:51

We have some arguments. That'd be fantastic. But, again, you know so, hopefully, if you're gonna draw down and you're you're seeing this, we can have already provided some value. And and in the next one, we'll hopefully provide a little bit more because, you know, like like Dave mentioned is that this is the time where you consider, is this a game that you've wanna be a part of? Right?

Michael: 43:12

Because they're emotionally no fun. And coming out to the other side, I just think every time you do it, and this is where I think we disagree a little bit as well, I think every time you come out of a drawdown, for me, it's made it easier to go into the next one. Because it's like, you know, the meme where the guy the two guys are in the gallows, and one of them is like turning to him and he's asking him if it's the first time. It's the same it's the same thing. I'm like, oh, I'm, you know, I'm in a drawdown because, the market's crashing because of some stupid tweet or something that's put out.

Michael: 43:43

I'm like, oh, it sucks right now, but I I'm sure I'll be fine, down the road. And, yeah, so hopefully we can provide a little bit of value even if it's at each other's throats for it. I think we'll be able to to come up with something in the next one. But as always, I'm Michael Nauss.

Dave: 44:01

And I'm Dave Mabe. Talk to you next week on Line Your Own Pockets.