Dealing With Drawdowns

The reality of trading is that a large portion of your time will be spent in some form of drawdown. In this post, I will take a look at my closed trades this year through the end of November. As November ended, I closed out the month at a new equity high. November saw me finally clawing my way out of my deepest and longest drawdown of the year.

Trade Graphs

Let's start by taking a look at my Equity Curve as well as my Drawdown Graph.

In this Closed Trade Equity Curve, you can see that most of the year was spent in positive territory, which is great. But the next graph, which is the Underwater Curve paints a different picture and relates some of the what the actual experience of trading is like.

It is very clear in looking at this graph, that the vast majority of the year was spent in some form of drawdown. In fact, there were 7 different drawdowns that were completed throughout the course of the year.

Drawdown Breakdown

Below is a table of the individual drawdowns, listed in the order in which they occurred.

When looked at this way, a few things stand out:

• There were four drawdowns that lasted more than a month.
• Three drawdowns were more than 100 bps.
• The worst drawdown lasted over 5 months.
• There were very few days between one drawdown ending and another beginning. Sometimes even on the same or next day.

Approaching Drawdowns

Mental Game

Setting Your Expectations

When you see that something like 95% of the time, that I'm in some kind of drawdown from my Equity All Time High, does it make you cringe a little? This desire not to lose, has to be overcome if you want to succeed at this game. Expect to have losing trades. Embrace it even. By focusing on how to handle and manage your losing trades you're focusing on the building blocks of a long-term profitable strategy.

Journal Your Mistakes

Every trader makes mistakes. By this I don't mean losing trades, but actual mistakes. This could be not following your trading plan, or some gap in your current knowledge of your trading strategy. These are moments to take notes about the mistake, and the events, thoughts and emotions leading up to it. In Jared Tendler's (@jaredtendler) The Mental Game of Trading, he refers to this process as Data Collection.

Journaling my mistakes helps to not only better understand my own psychology and how it's impacting my decision making in my trading, but it also helps me to separate out the trades I'm executing at my A or B game level vs my C game level. This gives me confidence in spots I'm executing well, but my drawdown is getting deeper, or it's taking a long time to get out. It helps me to focus on my process.

It also helps with recognizing patterns that are repeating that result in me making mistakes. For instance, I've noticed a tendency to get over confident after my big wins, or series of winning trades. My large 5% drawdown began just after closing my largest gain for the year. I was over confident and sized too large on a couple of trades trying to hit another home run, instead of focusing on my risk and keeping the balanced mindset that most of my trades are either breakeven or a loss. It took me 5 months to climb back out of the hole I started digging with a couple of greedy trades.

Focus On What You Can Control

Focus on your process (You do have a process, don't you?). What markets you're trading, where you are entering and exiting trades. How you are making those decisions.

Trading is a game of probabilistic outcomes. There will be streaks where you seem to be winning and streaks where you seem to be losing. Whether your last few trades have worked out or not isn't something that you can control. What you can control, is not going on tilt and trying to get back the money you've lost. What you can control, is not ignoring your stop loss because you are frustrated that your last few trades got stopped out, but would have worked. What you can control, is not taking profits early because you want to recoup the last few trades that were losing, and you don't want to risk having it turn back into a breakeven trade.

Focus on these aspects you can control, and give your system time to play out. Any approach to trading will have winning and losing periods of time. The worst thing you can do is lose confidence and abandon your discipline when you're in a losing streak.

Tactics

Size Down When Your Losing

Mark Ritchie II (@MarkRitchie_II) has said that you want a system that has you trading your biggest when you're at your best, and has you trading your smallest when you're at your worst. This is also a theme that has come up many times throughout the Market Wizards series of books. This makes a lot of sense to me, and is something that I have tried to put into place in my trading plan as well. As my drawdown from peak equity starts to increase, the amount of capital I'm risking per trade is also cut. I use a sliding scale that gradually decreases my risk as the drawdown worsens, and then raises it as I climb back out of drawdown, but there are any number of ways this could be implemented.

You'll Need to Win it Back Betting Smaller

If you follow this advice, you'll find yourself having to make back your losses by trading smaller size than you were when you lost the money in the first place. This can be difficult for people to accept, and it's precisely the opposite of what people emotionally want to do. People would rather "Double or Nothing" and hope they win it back in one trade, but that mentality is precisely how you knock yourself out of the game.

Keep Your Drawdown a Small Portion of Trading Capital

This one seems like a pretty obvious goal, so why am I including it as a tactic? Well, there is only one way to keep your drawdown a small portion of your trading capital, and that is to avoid risking too much on any single trade. You WILL have periods where every trade seems to lose. During each of my two largest drawdowns this year, I had 10 and 11 straight losing trades respectively. If I was risking 5% of my total capital per trade, then I'd have just lost half my capital. Not only is there a psychological punch to the gut that comes with such a drawdown, the math is really working against you.

Geometric Progression of Losses

As your drawdown increases, the gain you'll need to achieve just to get back to your previous equity peak grows exponentially. This can be seen in the following table.

In looking at this table, you can see you really start to handicap yourself by suffering through large losses of capital. If you have a 50% drawdown, now a 100% gain will only get you back to where to your previous high water mark. I want to try and keep my drawdowns at a level that one or two winning trades will take me back to all time closed trade equity highs. To do this, I really want to keep my drawdowns as a small portion of my notional risk capital. It is the reason that I'm quick to start scaling down as trades are moving against me.

Allow Winning Trades Room to Run

The error that a lot of traders seem to make, is that they get eager to take a trade off too early as it's starting to work. This temptation grows when you're in a drawdown. During my largest drawdown of the year, there were a couple of times that I could have closed out my open trades and gotten back to my high point, but I know the math of my trading doesn't work if I don't allow those trades a chance to turn into big winners. I think it's one of the hardest parts of trading successfully, to manage your winning trades, and this grows in difficulty when you're in a drawdown. Exactly how I try and manage these trades, is beyond the scope of this post, but it's important not to give into the temptation to take it off early, because you're afraid of giving back a small gain during a losing stretch.

Take Time Off Trading

This can be a valid tactic to deal with a particularly bad stretch, especially when you're finding yourself making lots of mistakes through your journaling process. As the drawdown continues and deepens, there is an accumulated emotion that is building up over time. Each day you sit down, the frustration from the previous days may not be fully cleared, and you're starting off closer and closer to the tipping point of going on tilt. This was something that I encountered in my days of playing poker. During some pretty large downswings, where it seems nothing is going right, the frustration wouldn't fully dissipate, and I'd find myself just going off early in a session at a bad beat or especially at mistakes.

At times like these, the best thing I could do for myself was to take a step back, and take some time off to regain some perspective, balance and composure. In trading as in poker, if you aren't performing at your best, then you likely have lost your edge, and you're only making the situation worse until you can get a grip on the situation.

Summary

Approaching drawdowns can be broken down into two different areas: Mental Game and Tactics.

Mental Game

• Setting Your Expectations - Over 95% of my trading year has been spent in some degree of closed trade drawdown.
• Journaling Your Mistakes - Keeping track of all the mistakes you make, and the situations and events that led to them is immensely valuable.
  • It helps you to identify and quantify your best and your worst, or your A - C Game.
  • It helps you to find the common threads between where your mistakes are occurring so that you can identify your biases that are leading to these mistakes.
• Focus on What You Can Control - You can control your adherence to your trading plan, but not the outcome of any individual or series of trades.

Tactics

• Size Down When Your Losing - Cutting exposure when you're out of sync with the market and have experienced a series of losses, allows you to keep swinging the bat so to speak.
• Keep Your Drawdown a Small Portion of Trading Capital - Losses work geometrically against you.
  • As your drawdown gets more than 10%, the return on your remaining capital needed to get yourself back to even really starts growing exponentially.
  • The only way I've found to keep the drawdown small is to keep losses small and the risk defined.
• Allow Wining Trades Room to Run - Avoid the temptation to book a small winner to give yourself a confidence boost during losing stretches.
• Take Time Off Trading - When you're totally at your wits end and deep in the hole, perhaps you need to quit digging, go outside and gain some perspective.