Managing losing trades is the most important aspect of any trading system, in our opinion. A loss as defined on our backtesting is any trade that had a negative PnL result when closed.
With stock pair trading, we focus on the following as our protection from risk of ruin and excessive drawdown:
1. SMALL POSITION SIZE: for any decent sized account (say $50k-$100k), our internal guidelines if for MAX 2% account equity risk per trade. Any account $100k+ we cut that to 1%. Let's walk that through, though the User Manual covers this in detail as well. Let's say in your Watchlist your pair with the largest Max DD in backtesting had a -15% Max DD. An accepted rule of thumb is to anticipate a worst Max DD in real trading of 2x in-sample back test (Tushar Chande). So let's take -30% as a worst case on a single pair. So let's say one has a $50k account and wants to size that trade for max 2% equity risk. 2% of $50k = $1000. That means one would trade the pair at $3333/leg. A 30% loss on the $3,333/leg pair is $1,000. One might set a Max Loss Alert here. Then again, one might not, as some pair trading research has shown that Max Loss stop losses reduce pair trading profitability (SaxoBank 2014). Up to the trader and their mental makeup.
2. TIME STOP: Best trades usually come good in the first 20 market days using 50 day lookbacks. Tying up capital in losers is not productive, especially if one is capital constrained based on your existing pairs portfolio. We chose 50 days for the FAST 50, we suggest new traders have a look and see what suits them best. They can run some backtests on various settings.
3. TRADE MANAGEMENT: Rules for moving stop to breakeven, trading to target etc. Critical in our opinion. We have two videos new traders can watch that take them through
our thoughts: