A sad (but typical) story (written by Matthew Klein of Collective 2)
“Dear Matthew: I lost money when I traded System X. But I’ve learned a valuable lesson. I’ll never do that again!”
He concluded his letter by saying:
“And now I’m going to start trading System Y instead. It has been performing great recently.”
Before I replied to my correspondent, I did a little research. I looked first at the initial system he chose – System X – a system that seemed to start off great, but eventually cratered, after placing a huge bet on the direction of the Euro currency that didn’t work out.
Next, I looked at System Y. This was the trading system that my customer chose after learning his valuable lesson. Alas, what I saw in System Y was not very encouraging. I saw the same characteristics that System X demonstrated before it collapsed: a series of beautiful, profitable trades; a sexy rising equity curve… and also a growing number of huge gambles that, so far, had paid off and been profitable.
But of course you know how the story ends, don’t you?
How the story ends
Let me show you the end of the story, using pictures.
First, here’s a picture of Trading System Y – remember, that’s the new system, which my customer chose after learning his valuable lesson. This picture shows what System Y looked like at the time the customer wrote me.
Now let me show you a picture of the system a few weeks later.
Why you should not fall for a beautiful picture
The customer made a foolish mistake when he chose system Y. He forgot the key rule of trading:
There is no such thing as a free lunch.
What’s that? You don’t remember that rule from all your trading e-books and seminars and webinars? Then let me put it in more familiar terms:
You can’t make money without risk.
Ah, that’s better. Whichever way you remember the rule, the point is the same. There is no such thing as a system that makes money without risk. If there were such a system, then I assure you it would not be offered on my rinky-dink web site – not for any price – and certainly not for $99 month, with a 14-day free trial. No, sir – such a system would be locked away, hidden deep underground, in a lead-lined chamber, protected by laser tripwires, and ringed by anti-personnel mines.
So if you see a system that looks too good to be true, then I assure you it is too good to be true.
Trading Systems = Risk
If you accept my rule about trading systems (You can’t make money without risk) then two corollaries flow from it:
If you see that a trading system is making money, it is taking risk.
and
If you see that a trading system is making a lot of money,
it is taking a lot of risk.1
These rules apply to all trading systems – whether the risk is visible to you, or not. What do I mean when I talk about risk being “visible” or not?
But not all risk is visible
But here’s the problem. Not all risk is visible. Even though Collective2 makes an effort to show a trading system’s risk, we can be wrong. Indeed, we can entirely miss the mark and not see the risks that are inherent in a trading system.
Let me give you an example.
An amazing system that never lost money in 30 years
Imagine that I tell you that I have found an amazing “system” that makes money, year after year. Sure – I admit – every now and then, it has a losing month or two, but overall, it generates steady returns every year. How steady? Well, I’ve been running the system for thirty years, and during that time, it never lost money overall in a single year.
Sound like a great system? Well, it was. It was called the U.S. housing market. And if you were a financial go-getter in the early 2000′s, you would have thought that buying mortgage-backed securities was a great strategy, because the underlying asset guaranteeing those securities (U.S. residential real estate) never substantially declined on a national basis – not since records started being kept three decades earlier.
A great system for about thirty years;
Until… well, until it wasn’t such a great system.
My point here isn’t to say, “The U.S. housing crisis was obvious.” It surely wasn’t – not to me, not to government officials, not to economists. My point is to say that – because people couldn’t see any risk – they assumed there was none.
Beautiful systems hide dark secrets
Instead of trying to figure out each system’s risk – whether it is high or low – what if we just start with the simple assumption that all trading systems are risky? What if we begin our analysis by stating the obvious: that there is no such thing as a free lunch. To put it another way, what if we admit the dirty secret or trading: that if you want to make money trading, you need to lose money sometimes.
It is my theory (and it’s only a theory, mind you – I’m no expert, and I could be wrong) that the trading systems that look the most beautiful are actually the most dangerous. This is another example of the “there is no such thing as a free lunch” rule. A system that looks great, without any losses, must surely be taking large risks.
On the other hand, an ugly system that makes decent money, but also sometimes loses money, might be exactly what it seems. That is to say: it might be a reasonable trading system that wears its risks on its sleeve.
Under this theory, if you see a trading system that looks beautiful, it isn’t because there are no risks. It is because the risk is hidden from you.
That’s why I recommend ignoring the beautiful trading systems, and sticking with the ugly ones instead.
A very well written account of what to look for in system.
The Dashboard doesnt profess to be the best system and have no losses and an ultra smooth equity curve, but it is consistent and has a really good win/loss ratio with high probability trades and low draw downs
remember if its too good to be true ie 100% gains per month believe me it is too good too be true run a mile !!!
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