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Understanding and Dealing with Drawdowns

Aug 18, 2007
We all have it and go through it one time or another and will continue to go through it. For others, drawdowns are more common than profit run-ups. Or worse, each drawdown is worse than the last. Its a never-ending cycle where these holes appear in our equity charts or account statement. How does a trader go about understanding and coping with them?

The main problem with drawdowns is that the majority of the traders dont know they exist and have ignored them. They have only calculated how much they will make and what they will do with that money earned. But little thought is given to how much each trade would bring and by how many losing trades it takes to wipe out the account. Those without a trading plan or a strategy will have no idea what their expected drawdowns will be. Only after they lose it all did they realize they need a plan to deal with losses.

First is to formulate a strategy and test and demo trade that strategy in a consistent way. Once thats done, start demo trading and begin keeping record and calculate all the losses, wins percentage plus countless other statistics to give an idea how the strategy fares. These demo accounts are offered free by many brokers. Among all of these ready-made calculations from the trades, there is a calculation for accumulated losses as well as average loss per trade. These two formulas show a strategys likeliness to losing periods and by how much, either in terms of consecutive losing trades or the loss since the highest equity amount. When knowing this in advance, we can expect it in the near future and not be tempted to doubt and even abandon the strategy when in fact its a profitable system in the long run. Most will never know because they cannot look beyond the current drawdown as part of the overall strategy. This is why testing and reviewing the strategy performance results is such an important part of trading, not just trading. This is where mechanical traders have an edge by following through a process of taking an idea into a final live trading phase.

Drawdown happens to everyone and can happen at anytime. Whether its caused by the strategy itself or by the traders own psychological and emotional issues, drawdowns is a fact of trading life. The only way to deal with it is to prepare for it and if possible, identify it and keep it to the minimum. This can be accomplished by reducing the size of the position, trade less or be more vigilant and cautious on each trade.

Drawdowns are the biggest reason why most people cannot survive trading because of the emotional stress that comes with them. These are moments when the trader is truly tested, some overcoming it by continuing and staying with the strategy until the drawdown in finished. Most, however, come undone by doubting their system and lose self-confidence as a trader. Eventually, these traders move on to other systems that will eventually go with their own drawdowns, which spiral to more losses, losing more equity. Its a vicious cycle where the biggest damage is not monetary but psychological. Eventually, these traders cannot handle the stress and quit.

Having explained the consequences of a drawdown, this is why it is so important to concentrate on finding the historical drawdowns associated with the strategy before trading them. This will prepare the trader to expect and deal better with the losing streak. When a person expects and prepares for the worst, he usually comes out feeling better mentally, especially when the result is not as bad as expected.

This mental state has to be nurtured and watched constantly during this period. More important than losing money is the loss of objectivity and confidence. So when this period does arrive, monitor and pay closer attention to each action and mental thought. In doing so, it will lead the trader out of the drawdowns with confidence intact.
About the Author
Larry Swing
CEO & Head Swing Trader
swing trading with mrswing.com
theboss@mrswing.com
+1 (281) 968-2718
Yahoo & Skype ID: larry_swing
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