Dynamic vs Drawdown Risk Management Strategies

Dynamic Risk Management is a Misguided Approach

• A student in the Pine Script Mastery Course suggested a dynamic risk management strategy that increases risk after a losing streak and decreases risk after a winning streak
• The student believed this would improve net profit for a strategy with a 50% win rate
• This approach is a dangerous misinterpretation of probability theory, known as the gambler's fallacy
• The gambler's fallacy states that after a streak of wins or losses, the probability of the next trade being a win or loss is higher than the historical average
• Each trade's outcome has no real correlation to the previous trade's outcome

Drawdown-Based Risk Management is an Alternative Approach

• The Turtle Traders, a group of successful traders, employed a drawdown-based risk management strategy
• This method reduces risk based on the extent of the current drawdown
• This approach does not rely on predicting the probability of the next trade winning or losing, which is impossible

Roulette and the Gambler's Fallacy

• The author discusses his personal experience playing roulette where he won a large sum of money through pure luck
• While casino games like roulette aren't directly related to trading, they demonstrate the gambler's fallacy in action
• The chance of landing on black or red in American roulette is not 50/50 because of the green zero
• European roulette has a slightly higher chance of landing on black or red due to having only one green zero
• The author's unexpected wins were due to luck and not skillful prediction

Creative Risk Management Techniques

• Despite the gambler's fallacy, there are creative position sizing techniques and models that can improve a trading system's edge and risk-adjusted returns