Managing Drawdowns is a traders nightmare. It happens to all of us and it skews your ability to think clearly. The beginner becomes desperate to hunt for the next kill to make up for endless losses. It is particularly difficult when a great system has a drawdown right from the set go unawares of the profit curve is around the corner.
Beginners would not have a clue how to manage drawdowns; it should be part of a 'five year plan' and estimate your drawdowns over five years. If you are unable to estimate this vital statistic I suggest you fine tune your risk management techniques get to know your system; no matter how simplistic it may be and find out what the drawdowns are likely to be and prepare for them. It is imperative to try and forecast your trading business your profits and losses in terms of percentage. You need to keep atop of everything and drawdowns is one of them. It is the most psychologically challenging task of a trader to comprehend and execute correctly.
Some tips to manage drawdowns.
Hedge
Hedging can be the difference between an empty account and a funded account. When you hedge, you prevent further losses. Say you take a bad trade of lot size 1, and you are on -150 pips. And let us say you have a $300 account. This means that half of your capital is on the ropes and things are not looking good.
Do Not think the market can not wipe you out in one night because IT CAN.
The first thing to do is to hedge. Take an opposite position of the same lot size.
Doing this, means you have frozen the losses. IT DOESN'T MEAN YOU ARE IN PROFIT. It just means that you are not in fatal danger anymore.
When the price moves to the oversold/bought position you close the hedge immediately and take advantage of the oscilations by moving into other markets. This WILL NOT WORK WITH VOLATILE MARKETS PERIOD. AVOID VOLATILITY DURING DRAWDOWNS IF YOU RESPECT YOUR ACCOUNT.
Reduce position sizes
When you have forecasted your losses you are very well prepared to dramatically reduce your position size in a timely manner for more accurate risk-adjusted returns and losses in line with your system.
If your average starting position is $10k and experienced a 10% drawdown and forecast a further 20% drawdown it is imperative to slash your position sized to approximately a third of average position size. SO now your average starting position should be $3k instead of $10k.
Only incrementally increase position sizes by approximately 10% when profit chart improves.
These are the two main strategies but to recap drawdowns must be viewed within a larger framework. One reason that drawdowns affect traders so acutely is because they aren’t viewing their trading in its entirety – over a long period of time. Many traders tend to focus on trades in isolation instead of seeing them as part of a “pool of trades” executed over an extended period of time. This mindset causes losses to be felt more deeply, as opposed to the mindset that see losses as small instances in the grand scheme of things.
It’s imperative to understand how these emotions affect our trading behavior. Becoming too elated over the success of any one trade often leads to a feeling of invincibility and WRECKLESNESS. This is a very dangerous state to be in, as it easily causes sloppy trading decisions and the taking of unacceptable levels of risk, which can result in large losses and a new career change. Conversely, dejection over failed trades can lead us towards desperation and anxiety, which often results in poor trading decisions based upon a need to validate our feeling of personal competence.
The latter feeling is also counterproductive because it has a tendency to make us question our trading methodology. We may ask ourselves “Maybe my system is flawed”, or “I was following all of my rules with discipline, why hasn’t it worked?”. Most of the time, if you’ve done your planning and executed it properly and stuck to your trading plan with discipline, it’s not your particular trading methodology that is flawed. The simple fact is that every method will have a certain percentage of drawdown.
Sometimes those losses come one after another in a seemingly endless fashion. But, nine times out of ten, the upswing is usually just around the corner, if only the trader will have the courage to persevere through the losing streak. Sadly, it is during these losing streaks that many traders decide to hang it up and abandon trading altogether. As stated above, traders should focus on profiting over the long run, instead of trying to enrich themselves on individual trades.
