5 tricks to take the volatility out of your returns

Volatile returns are the ups and downs on your profit curve.

We hope that the overall direction of our profit curve is an upward one, but we often get distracted by the percentage gains, and we forget to look at the volatility behind those returns …

On the chart above, the returns with high volatility have earned more money, while the low-volatility returns have made less profit – but have probably allowed their user to get a better night’s sleep.

Volatility is both the friend and the enemy of the trader – so it’s important to understand it’s roll in your actions, and to keep it on a leash.

If market returns had no volatility – we simply wouldn’t get trading opportunities. The markets would chug along, maybe offering the kind of returns you’d get from a bank account.

Volatility is what gives us the incredible ability to do better than this.

But volatility left unchecked will clear out your trading account. The adage goes that ‘your biggest drawdown is still ahead of you’ – so we have to be prepared for those downs as well as the ups.

Plus, if you’re compounding your profits, volatile returns can really eat into your long-term results. If you’re in any doubt about that, just check out the figures in this article.

So, we should be looking for lower volatility – and it’s worth giving up some returns to achieve this. As it’s likely to benefit us in the long term. With this goal in mind, here are some tools you can use to achieve it …

1. Reduce risk

Volatility and risk go hand in hand, so by just lowering your stake sizes, you will cut the volatility of your returns. Yes, it does mean that a system which creates 50% gains p.a. with a 2% risk profile, will only make you 25% p.a. with a 1% risk profile. But you will be protected from drawdowns – and all trading methods suffer from those!

2. Diversify

The larger your trading fund, the greater the ability you have to diversify. If you can spread your risk across multiple markets, that’s a good thing, but you need to be able to reduce your stakes accordingly (otherwise, you’re just doubling up risk).

So, if you’re trading the German DAX with a stake of £5, you could be spreading that risk across the DAX and the French CAC. But there are a couple of issues to bear in mind: first, diversity can be tricky to manage as each instrument has its own nuances, so it’s easy to get out of your depth information-wise; and secondly, many small home traders are limited by minimum stake sizes from opening up multiple trades.

3. Use a drawdown limit

I’m a huge fan of the drawdown limit as a way to halt losses.

A drawdown limit is a loss limit that you set yourself. It will be a maximum percentage you can lose on a day, week, month, year … at which point you stop trading.

As an example, with one of my day trading methods, which makes either 2% profit or 2% loss per trade, if I find myself 6% down, I’ll stop trading. Therefore, the maximum I can lose in a day is 6%; while the maximum I can gain in a day is unlimited. I’ve naturally swung the odds in my favour.

When you’re in the midst of a losing run, the natural human tendency is that we ‘deserve’ a winner. That the market ‘owes us’ some payback. Of course, this is the psychology of the roulette table (and is why casinos are so rich). The reality is that losing runs often come along because market conditions just aren’t right for our trading style. So, by stemming our losses, and taking a breather – we’re better placed to come back to the table when market conditions have had a chance to change.

4. Reduce time you’re in the market

I’m not suggesting here that you adopt a scalping strategy – far from it.

In fact, it’s a common error made by new traders, keen to reduce risk, they’ll seek out strategies that use the tightest stops. This is a fast-paced sport, and more akin to gambling than investing.

When I talk about reducing your time in the market, I mean ruthlessly cutting losses when trades aren’t pulling their weight, rather than giving in to wishful thinking and hoping that they’ll ‘come good’ in the end.

5. Reduce the number of trades you take

If you feel that every time you make profits, you’re rapidly giving them back, this could be a sign that you’re taking lots of signals, rather than focusing only on the best ones.

Overtrading damages our results with a two-pronged attack: dilution and risk. You’re diluting your winning trades so excessively that your success rate will move lower and lower. And all those weaker trades are exposing you to the same risk levels as the stronger signals, yet aren’t delivering the same rewards.

By keeping a good trading journal, you can monitor your results, and look for filters that can cut out your weaker signals.

Each of these tricks will have the effect of reducing your bottom-line profit figure at the end of the month. Perhaps that something that doesn’t interest you?

But lower volatility also means that:
– You’re less likely to take a serious drawdown to your account
– You’re less likely to give up trading because of the stress it’s causing
– Compounding will work better for you, so you wealth will grow over time

So, if lower volatility pays out with a happier, longer, less-stressful trading experience, it might be worth sacrificing a few percentage points in profit in the short term …

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10 tricks to improve the odds of success Two tricks to reduce drawdowns