In the previous post, I started highlighting Grid Trading’s potential of being able to absorb losses. Well, in this post I’m going to explain to you what this really means, and what happens when this potential is unleashed
So in the previous post we compared the 2008/2009 GFC period for two Grid Trading strategies, Restricted vs Unrestricted grids. The Unrestricted grid played out better as it never took a loss – ever. However, this lead to, at times, over 20% draw-downs in equity. As mentioned earlier, Grid Trading’s weakness is a trending market and during the GFC there was a huge momentum rush as everyone pulled their money out of the system and unwound their positions.
Now I have written a Grid Trading simulator in C# to simulate various Grid Trading scenarios. In this scenario, prices move up and down by 1-unit. Positions are of size 10 units. The Grid is an Unrestricted grid, meaning there are no stop losses, only limits. Limits are set at open price plus 1 unit. The simulator has calculated all the possibilities after 20 units of time, assuming in each unit of time the price either moves up 1-unit, or down 1-unit.
So, let’s look at the worst case scenario – the grid trends away from us right from the start, and continues to trend for the whole time.
So to remind you how the strategy works, at each unit of price we enter Buy and Sell trades. In this scenario the buy trades take profit after 1 unit of price. Without getting into too much detail, the Sell trades are staying open since we have no stop losses, and carrying our losses. Worse, they are being compounded as the price trends away from us. In the end, we end up with 20 open trades in loss. Given the amount is 10, the largest open loss has a position of -200, the next would be -190, the next -180 and so on.
If you were to mathematically calculate these losses (using the Triangular number equation) you would end up with -2100. However, on the way each of our buy trades have hit their limits, 20 of them to be specific, so we end up with an open loss of -1900 … which matches the simulation above.
That was the simulation of the worst-case scenario, let’s look at the best-case scenario.
This best-case is a mean-reversion strategies dream with the price simply reverting around a common point. Each time the prices goes up or down, one of our trades (since we are trading in both directions) wins. Of course to make money it does not have to be the base-case every time, this is also a very good scenario.
Or even this
As you can see, as long as the price comes back, we will make money. If we were using the Restricted Grid for the above example, we would have been stopped out for a loss. However, we can see that the price turned around and came back into profit. Even better, we will continue to make money as the price stays within the price range that we have experienced.
This is key here – this price range concept. If we can determine the maximum range of prices, we can calculate what our maximum drop in equity can be – i.e., what the max amount of loss trades we are carrying on to. This number is going to be fixed.
However, what we cannot calculate is our profit. Our profit is unlimited because as time goes on, assuming the price stays within the price range, we will just keep making money. Take the following for example:
You can see that if the price stays between 5 and -5, we will just keep making more and more money as time goes on.
This means, our losses are fixed while our profits are unlimited. This is the real potential of Grid Trading and this is why it is so appealing. You don’t need to know what direction the market will go, and you can make unlimited money. However, you need to be ready to absorb a certain amount of losses before its real potential can be unleashed.
Obviously there have been some assumptions about price range of currencies, and we shouldn’t forget about the swap rates, so more on these two in the next post.