Many talk about the psychology of trading and how important it is to develop a mindset that is conducive to trading. However, there seems to very little written about how to live through the daily rigors of trading. How to live through the daily, weekly or monthly drawdowns that plague us … well daily, weekly, monthly.
Hopefully, this article will help you to do just that.
Notice the title of this article is not live through “a” drawdown but live through drawdowns – plural. And I’m not talking about the MAX drawdown, I’m talking about the drawdowns you will be in most of your trading career.
First of all, let’s revisit, what is a drawdown?
A drawdown is a dip between new equity highs in your equity curve, it’s as simple as that.
So, by definition, a trader will spend most of his/her time in drawdowns.
Some traders think drawdowns as an extremely rare event, or at most, a once a year or quarter event – but the fact of the matter is that traders will spend more than 75% of their time in a drawdown.
Negotiating drawdowns and all the emotions that swirl around them is the key to successful trading, bar none.
If you can’t survive a drawdown you will not be a consistently successful trader. It’s that simple.
Alice through the Looking Glass
Have you ever felt like Alice in the movie, “Alice through the Looking Glass” The show opens with Alice trying to steer her ship through a narrow passage that is wrought with rocks? While a howling wind is throwing it around like a kitten playing with a ball of string?
What I hope to do today, and with the next few newsletters, is to help you expertly steer your vessel through the treacherous times we all know are always ahead of us. So if you’re going to spend more than ¾ of your time in this quagmire called a drawdown, you need to learn how to live through them.
Here’s a list of 5 things I think you should do to help you live through the drawdowns.
1. Know the drawdown numbers of every system you trade as well as you know your birthday.
This is not meant to be funny.
Your ability to handle drawdowns, hands down, is dependent completely upon how mentally prepared you are for them. This means it’s crucial you know your system’s past Max Drawdown, as well as you, know your own birthday. However, just like that birthday, you should expect to visit a drawdown of equivalent size once a year then, an even bigger one sometime in the future – we’ll talk about this later.
If you’re trading, and consider yourself a trader, you need to be very aware of what will happen to your account during that drawdown. When you do, you will be mentally prepared and have the intestinal fortitude to stick with the program through these tough times.
If you’re not prepared mentally for the drawdown, you will make emotionally driven decisions at the worst possible time in the worst possible place. These emotional decisions lead to that trait all bad traders share – getting out at the lows. How many of us have done that?
One of the main benefits of trading with an algorithm is to eliminate those counterproductive emotional decisions. Please don’t offset that advantage by acting emotionally when in DD.
2. Measure your drawdown.
Don’t we all look at the drawdown stats from the evaluator sheets and say, ya I can live with that, seemingly giving them their due. Then we see those drawdowns in OUR account and, lo and behold, we react like deer in the headlights and say, “What is happening? I didn’t expect this.”
It’s completely unreasonable to expect a trading system to make money each and every day of each and every month. Things simply don’t go UP, nor DOWN, forever. They peak. They valley. They go through up cycles and down cycles.
3. Assume the worst drawdowns the system will ever encounter is in the future.
Just like death and taxes – you can’t escape them. The only way you can avoid death is not being born – silly but true. The only way you can avoid taxes is never making, or spending, any money – silly but true. The only way you will never encounter a drawdown is by never trading. These all seem silly but they are true, aren’t they?
So if you want to trade you need to accept drawdowns but more than that you also need to expect a new max DD will always take place in the future – after you’ve invested, of course. If you approach your trading accepting DD and have an expectation of a new MAX DD somewhere in the future, you’ll never be a nervous wreck who can’t think straight when it happens. You will take it in stride, step back, and assess the system rationally.
4. Accept the fact there’s no such thing as risk-free returns, the larger the returns, the larger the risk.
The larger the returns, the more volatility in your equity curve. You can easily get no risk by investing in US saving bonds, but will you be happy with gains of just 2% per year. Probably not, and for that reason, traders are on the lookout for larger returns. But how many are prepared for the higher risk and volatility that accompanies that higher return?
Our natural tendency is to stop that which is causing us pain (losses), and so a human’s natural inclination is to quit a system when it’s in a drawdown because it “just doesn’t feel right.”
You have to overcome this very basic human instinct by making it all about the statistics and being prepared.
Set a realistic line in the sand, a line based on your tolerance for losses and the stats of your trading system. If you do this BEFORE you start trading and make a pact with yourself to not flinch until that line is crossed. If you do, your daily mental battle of whether you should stick with the program or dump it, has been won. You’ll have what very few traders have, intestinal fortitude.
Part of the problem with trading with systems like QiT is that it’s too easy to quit. All you do is stop trading. Heck, you don’t even have to pick up the phone. All you do is stop. An investment in real estate or a hedge fund for example often takes more time to liquidate, giving traders time to let the emotion run its course and evaluate from a place of rationality.
It is important to note the corollary to things don’t go UP forever: things don’t go DOWN forever either. Trading systems are very cyclical, they make money, then they lose money, then they make money etc. It pays to stick with a system in its downturn because their cyclical nature means they will come out of it.
5. Quit once the system has fallen below its circuit breaker.
You know your drawdown numbers, you measure your drawdowns, you’ve accepted drawdowns, and you expect to have another large drawdown in the future. But there is one more very important question to answer. What if the drawdown I’m in is more than a drawdown and the system has broken?
You need to have a mechanism to help you answer this question. You need to have a mechanism to know when to move to cash. You need to have a line in the sand.
Fortunately QiT’ has your back and has line in the sand. Its called the Equity Curve Circuit Breaker. A moving average on the equity curve that we use to move to cash once its violated. Without this line, you could go crazy wondering whether the current drawdown equates to a “broken system.”
Drawdowns, like taxes and death, are unavoidable, are real and will occur as long as you trade. They are that terrible feeling in the pit of your stomach. Drawdowns happen. Drawdowns will happen again and again and again. These are the facts. Successful traders know this so they prepare for it.
We’re the Plan in “Plan your Trade and Trade your Plan”