Today’s Trading Lesson From TradingMarkets

Surviving A Drawdown

Drawdowns are a trader’s worst enemy.  None of us
is immune. Therefore, in order to survive, we must take steps to help prevent 
and minimize them. When faced with the inevitable, we must then take steps
toward recovery.

Background

As mentioned in prior money management articles,
drawdown is simply the amount of money you lose trading expressed as a
percentage of your total trading equity. If all your trades were profitable, you
would never experience a drawdown. It does not measure overall performance, only
the money lost while achieving that performance. Its calculation begins only
with a losing trade and continues as long as the account hits new equity lows.
As drawdowns increase, the percent of gain required to get back to breakeven
increases geometrically. For instance, if you lose 10% of your capital, you must
make at least 11.11% on your remaining capital to get back to breakeven. This is
illustrated in the table below.

 

 

This becomes more pronounced when shown
graphically. Notice that percent to recover rises geometrically as percent of
loss increases (lower blue line).

 

 

As mentioned in my book and other articles on the
Website, I strongly urge you to make copies of the above and paste them near
your trading desk.

An Ounce Of Prevention

An ounce of prevention is worth a pound of cure,
especially  when it comes to drawdowns. Proper money management which emphasizes
the use of protective stops is crucial. I, and others, have many articles on
this subject under Trader’s Lessons. I strongly urge you to study these. Keep in
mind, though, you will still be exposed to drawdowns even though you implement
strict money management. Therefore, it’s important to recognize what may be
causing the drawdown and more importantly, how to stop and recover from it.

Is It Me?

It’s beyond the scope of this article to cover
all the psychological pitfalls of trading. However, when faced with a drawdown,
you should always look first within yourself to make sure that nothing has
recently changed. Ask yourself general questions like: Have you been doing your
homework and managing risks? Have you changed your trading style on one or a
group of trades? If so, is there a personal reason? Have you recently incurred
any major life events? Have you been well? Are their any distractions that have
been keeping you from focusing?

Or The Markets?

Futures Truth once equated a trading system’s
performance to dancing to your favorite song. As long as your song is playing,
you seem to float on air. However, it becomes very difficult to dance when the
next, unfamiliar, song begins to play.  In trading, when conditions are
favorable to your methodology, you will be profitable. However, when the
environment changes, unless you stop trading or change your style, you will
likely lose money. As an example, the summer months are notorious for being
choppy, as many traders are on vacation.  During these times, momentum-based
methods, which depend on prices to persist in the direction of the trend, tend
to under-perform countertrend-based methods. During these times, the momentum
trader should scale back on his trading and/or become very selective. For me,
this means only taking trades with the sector, the stock and market-timing
systems all set up.

If You’re In A Hole, STOP
DIGGING!

When faced with a steep drawdown, you must take
actions to stop it. The good news is, stopping a drawdown is  not difficult. You
simply stop trading. Period. 

Recovering

By not being in the markets, you will be able to
sit back and analyze the situation without the emotions that come with market
exposure. Make sure you fully understand all of the reasons that caused your
drawdown. Look within yourself and review your recent trades/trading journal.
Once you have identified the causes, you are ready to begin paper trading. Keep
accurate records and time stamp your “trades.” Or better yet, have someone help
you by “taking” your trades (or use a tracking service). Make sure you add in
commissions and a reasonable amount of slippage. 

Once you become profitable in paper trading (and
keep in mind that most ARE profitable in paper trading, as it lacks the emotions
associated with having real money on the line), slowly ease back into
trading. Trade at a size that seems almost inconsequential to you. If this
trading is profitable, then slowly begin to increase your position size.
If you once again encounter losses, then scale back in your trading or go back
to paper trading.

Repeat the above process over and over until your
trading improves. Keep personal notes and notes on the market conditions. Learn
from the experience so that you’ll be better equipped to handle the next
drawdown.

Summary

Even with the use of strict money management,
drawdowns are inevitable. Therefore, you must take steps to recognize what’s
causing them, take steps to stop them, and then take steps towards recovery.