In our NetPicks Quantitrader service, where we provide a fully developed, simple to follow stock trading system (Free Trial Here) we frequently discuss the importance of understanding drawdowns.
We all know it is very important to develop a mindset that is conducive to trading. One of the most important parts of that mindset is how to handle drawdowns. How to live through the daily, weekly or monthly drawdowns that all traders have to live through.
What’s a Drawdown Really?
Ok so what is a drawdown? A drawdown is the valley between new equity highs on your equity curve, it’s as simple as that. So, by definition,you can see a trader will live most of his/her trading career in a drawdown. 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.
Take a look at this equity curve of one of NetPicks Quantitrader (QiT’s) systems. It has a Compounded Annual Return of 56% but a Max Drawdown of 21%. Many would look at the 56% and think, WOW but not understand the reality of what it takes to get to that 56%.
The Green boxes are new equity highs. This is when your account is making more than it’s ever made trading this system. These are your feel good times. Now look at the red line when it’s not in one of the green boxes, for 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 and that it may be more.
Learn to Live Through Drawdowns
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
Your ability to handle drawdowns, hands down, will depend completely, 100%, on how mentally prepared you are for them. 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. If you do, you will be mentally prepared and have the intestinal fortitude to stick with the program through these tough times.
One of the main benefits of trading with an algorithm, like the ones we use at NetPicks Quantitrader (QiT’s) is to eliminate those counterproductive emotional decisions. Please don’t offset that advantage by acting emotionally when in DD.
2. Measure your drawdown
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 and valley, go through up cycles and down cycles.
The MAX drawdown for this system is 21% and the drawdowns experienced so far have been 10% and 9.7% both completely in the realm of possibility.
I believe this simple exercise will get you used to what a drawdown looks like and will help you to live through them, since most of your time will be spent in them.
3. Just like death and taxes – you can’t escape Drawdowns
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 probably 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
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 trader’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.
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 your predetermined “get out”
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 is 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’s line is the 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 are unavoidable, just like death and taxes are unavoidable. Learn to accept the fact that drawdowns 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.