Many talk about trading psychology and how important it is to develop a mindset that is conducive to being consistently successful at this endeavor.
However, there seems to very little written about how to actually navigate your trading vessel through the swells and currents of drawdowns so that treacherous, ripping ocean waves do not crash us against the jagged rock cliffs of the shoreline. In other words, how to sail through the daily, weekly or monthly drawdowns that threaten our resolve … well daily, weekly, monthly.
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.
I’m sure there have been many times when you have 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.
Since this is such an important subject I will be addressing a different aspect of living through these times in the next few newsletters so I can expound upon each point.
What is a drawdown?
Before we start, I should probably make it clear that when QiT talks about drawdowns, we expand our discussion to include Max Drawdown, Average Drawdown, Max Drawdown Duration and Average Drawdown Duration. Not just the MAX drawdown. But to make this discussion simple, I will defer to Max Drawdown, which is the dip between new equity highs in your equity curve, it’s as simple as that.
So, by definition, you can see a trader will spend most of his/her time in drawdowns. Some traders think drawdowns are a 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 85% of their time in a drawdown.
Here’s an equity curve of a very successful algorithm. The Green boxes are new equity highs. This is when your account is making more than it’s ever made trading this system. This when you do your happy dance. This is when you start dreaming of the house you will buy in Thaiti. Now, look at the red line. This is when you’re not in one of the green boxes. This is “the rest of the story.” The red line is you living in a drawdown. I’m thinking 75% of your time in a drawdown may be a little too conservative.
Considering you’re going to spend more than ¾ of your time in this quagmire, it behooves you to learn how to live through it/them.
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 drawdown numbers as well as you know your own birthday. Because, 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.
You’re trading and consider yourself a trader. You need to be very aware of what will happen to your account during these drawdowns. When you do, you will be mentally prepared and have the intestinal fortitude to stick with the program through these challenging times.
If you’re not prepared psychologically 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, selling at the lows. Or its doppelganger, buying at the highs. How many of you have done that?
One of the most important benefits of trading with an algorithm is to eliminate those counterproductive emotional decisions. Please don’t offset that leverage by acting emotionally when in a DD. Avoid ending up like the ships that followed Alice, who were not able to captain their charges through the treacherous waters and sank.
We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie
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