Ride the Drawdown Storm

It’s almost inevitable. You get a rise in market volatility and you see folks get hurt. Markets move faster, further and change direction quicker than people have become used to.

For traders who aren’t prepared, this can spell disaster.

Not only do they face a run of poor of results, but the aggressive movements which they aren’t used to can be seen as a threat and in turn, they hand over control of their trading to their Chimp.

Not good at the best of times.

So it’s essential to understand and expect these periods if you’re going to ride the drawdown storm.

The Inevitability of a Poor Run

The nature of trading is that you cannot tell whether your next trade will be a winner or a loser before you take it. Over a set of many trades, an edge has a historical probability which could well carry forward to the next set of many trades that you’re about to take, given that the trading idea has substance and market conditions are right (and it’s not simply some random historically curve-fitted system).

But you simply can’t know what the distribution of winners and losers is going to be.

Over the course of many trades there will be winning streaks.

Over the course of many trades there will be losing streaks.

Indeed, there will even be periods where winners and losers are distributed evenly based on the historical win rate.

The problems begin however, when we start losing faith in a strategy and interfere with it particularly in periods of drawdown. We already know that it tends to be human nature that we’re riskier with losses than we are with wins so there’s a real danger that your results end up being the victim of self-sabotage.

That Pesky Chimp

There was an interesting piece on TV the other day about a boxer who had ended up in a coma after a fight. The part I was particularly intrigued by was that he remembered nothing of the fight itself.

He remembered the build up on the day of the fight, but not the fight itself.

Now I’m not a big boxing fan or anything, but this is my view. As much as there’s strategy, there’s not going to be a great amount of time to think when you’re getting hit in the face again and again. The brain uses rudimentary systems to make decisions quickly and sometimes the Chimp within can take control – i.e. the raw survival instincts can kick in. If this is what happened on this occasion, it would explain the fact that he didn’t remember the fight.

Because the short-term conscience actions had not had the chance to be committed to long-term memory once the boxer had gone into the coma.

The Chimp can and does take the trading reins from us all on occasion. However, the extent of the impact it has varies greatly.

Some allow it to retain control and take trade after trade, some walk away at the first sign of it making an appearance and some are able to calm and cajole it into taking a back seat.

Making sure that you’re a trader who minimizes your Chimp’s impact is a luxury that you do have, unlike the boxer did on this unfortunate occasion. But it’s also easy to give your Chimp more fuel too.

If you fail to assess the performance once you’ve fully calmed down, your Chimp is only going to see future events of a similar nature as a threat and either fight harder or freeze. What you must do is shortly after a trading abomination, work to understand just how it occurred and what triggered the loss of control and trading outside of your strategy rules.

If you take the time to properly process the experience, you are likely to be able to deal with it better in the future.

Staying the Course

Recognizing the types of personal triggers you have is an important step. It’s also crucial to change your mindset. Accepting losers as part of the game even if they are really quick to-the-tick stop-outs or they are slow, grinding, relentless marches against you.

But once you’ve done this, another powerful technique is to see just how much this costs you over time. If your Chimp starts to get aggravated while you are trading, it’s much easier to persuade it to calm down when you remind it about the cost of trading emotionally.

In the example above, I’ve created a randomly generated positive equity curve for a set of 50 trades. During periods where there are a couple of losses in sequence, I’ve doubled 5 of the losers – not something way outside of what you might expect from a trader who is struggling.

What you can see here is so typical of many traders’ equity curves. If they could just eradicate a few of their bigger than planned for losers, they’d be making money.

The Curse of the 1 Lot Trader

This idea is particularly important for traders who are starting from a low base and looking to build up their account. The issue for people starting with a small account is that as soon as they increase their size, they’re usually increasing their risk by 50-100%.

If you start with a 2 lot, the smallest increase to 3 lots is a 50% increase. Starting out trading with just 1 single contract means that any increase in size at least doubles your risk.

While you cannot predict when and where runs of poor performance will occur, if anything they’re more likely to happen after a period of good performance. This frequently means that a trader builds their equity on whatever size they are trading at the time and then increases in size, only to start to see a run of poor results.

So the drawdown is effectively magnified in size.

Imagine what the equity curve we looked at before would be like if the trader was simultaneously increasing their size and not taking their stops!!

When you think about it like this, it’s no wonder that there are people who a perpetually struggling to achieve consistency. Many years ago, a systems trader once told me that the biggest problem he faced with his strategies wasn’t finding good entries or even managing a trade properly – it was adjusting the trade size effectively.

Ride the Drawdown Storm

It’s such an important part of trading effectively over the long run, but many just don’t address it. When you do go into a bad drawdown, if you haven’t planned for how to deal with it (let alone planned to have enough capital to deal with it), it’s all too easy to lose the plot.

Don’t be a trader who fails to learn from moments like this.