What Every Trader Must Know About Drawdowns

[analyst75 12]

“However, it is pleasant to win over the long term. Contrary to popular opinion, losses are part of winning. Take sports for example.” – Markham Gross

 

A drawdown is the peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the trough. A drawdown is measured from the time a retrenchment begins to when a new high is reached. This method is used because a valley can't be measured until a new high occurs. Once the new high is reached, the percentage change from the old high to the smallest trough is recorded (definition source: Investopedia.com).

 

As you can see, drawdowns (or roll-downs) are periods when you experience losses and your account goes down. If you open an account with $10, 000 and it drops to $9,200, then you experience a drawdown of 8%.

 

Causes of Drawdowns

Let’s put the issue of trading with no stops and high risk aside. Let’s imagine someone is using a good strategy that makes him cut his loss at 50 pips and runs a profit until it reaches 200 pips. That’s a good trading idea which makes money when currency pairs trend nicely. Nevertheless, when a period of drawdowns comes, more stops would be triggered and take profit levels would hardly be reached. The few take profit levels that are reached would be too few to recover the too many stops that are triggered. You open many a trade and it moves in your favor by a few or several pips and then turns negative, hitting your stop. For days, weeks, or months, false breakouts wouldn’t be a curiosity and sustained trending movement would be scarce.

 

Trading ideas that let profits run are the best, but they generally suffer when the markets enter equilibrium phases.

 

As in real life, doing the right things doesn’t always make you appear smart. In fact, you may sometimes look stupid by doing the right things. A trader that uses a stop may appear stupid when they are stopped out on a trade that eventually reverses and turns positive. A trader may appear stupid when a position they are trying to ride fails to meet its target, turning from positivity to negativity. But in the end, we’ll reap the benefits of doing the rights things.

 

Soon, a time would come when the situation will change and the person will recover the losses within days, weeks or months.

 

Treacherous Statistics

Look at the long-term results of the strategies below:

 

Strategy A:

Growth: 343.80%

Drawdown: 37.45%

Monthly: 19.09%

 

 

Strategy B:

Growth: 119.40

Drawdown: 22.08%

Monthly: 10.51%

 

Strategy C:

Growth: 12.04%

Drawdown: 11.16%

Monthly: 0.49%

 

You can see that the strategies above have made nice profits in the long run, but not without roll-downs. Strategy A has earned a profit of 343.80% over the years, but it also went thru periods of losses amounting to 37.45%. The users of the strategies obviously deal with the roll-downs successfully; otherwise they’d have disappeared.

 

One marketer was recently creating hype that he’d a strategy that could turn $500 into a growing monthly income. As you know, the job of marketers is to emphasize the bright side of what they sell, while glossing over the dark side. It’s like when a religious preacher is telling people nice things that will happen to them if they join her/his religion and become responsible, without telling them the reality that religious people aren’t also immune from suffering. For instance, when an earthquake occurs, it doesn’t avoid the religious people in the region.

 

I never tried that hyped strategy – though I’ve tested over 250 strategies in my entire career. There’s no perfect strategy and there won’t be one. All excellent trading strategies experience drawdowns. All super traders experience drawdowns, albeit victoriously.

 

Sadly, the subject of drawdowns is the least mentioned in the trading industry, and there’s only scanty literature about the subject, in spite of the fact that it’s one of the most important topics in trading. Drawdowns must be experienced from time to time by all traders irrespective of age, intelligence, expertise, years of experience, risk control ability and strategies. This is where majority of traders fail. Your ability to deal with drawdowns triumphantly is the greatest determinant of the end game and your ability to enjoy a long-lasting career.

 

The smaller a loss is, the easier it’s to recover. The bigger a loss is, the more difficult it’s to recover.

 

There are periods when you’ll make money; there are periods when you’ll lose money, and there are periods when your performance would be flat (you’ll never go up or down). There’s no way around this fact. There is no way around the fact that you must sustain losses that you must eventually recover. Flat and drawdown period may even be longer than you expect. Switching strategies isn’t the way out. Can a rolling stone gather any moss?

 

That’s why it’s unrealistic to set a weekly or monthly target in a world in which you can’t really predict the future. That’s why it’s realistic to open a trade only after you’ve imagined the worst-case scenario. With that kind of mindset, you’ll realize the folly of not using stops and the folly of trading with large lot sizes. However, most of us have serious psychological and emotional problems.

 

One of the most frustrating things is to keep on trading when you keep on making losses. Your hope of a monthly income would be dashed and your courage will evaporate. The frustration would even become more intense, especially if you live in a country where you’ve to generate your own electricity and fuel is extremely scarce and expensive.

 

 

What Good Traders Experience

I remember what happened to me in the year 2011. I was making good profits for about 4 months: up to 30% (6000 pips). Then suddenly, the market conditions change and I was having losses after losses. I kept on managing my risk, being faithful to the system I used. The losing periods lasted for about 3 months and I went down from 30% pips to 15%, and suddenly… the market conditions became favorable again and I finished that year with 49% profits.

 

In a typical year, you can make 10% in January and 6% in February. You can make 3% in March and lose 9% in April. You can lose 4.5% in May and lose additional 5% in June. You can gain 4% in July and lose 4% in August. You can gain 11% in September and gain another 6.5% in October. You can gain15% in November and finish December with another 2.5%. How much would the trader end up with in the year? This is the reality of trading, which you must accept or go do something else.

 

Many so called Forex traders are gamblers who think they’re good. They lose hugely or earn margin calls during drawdowns.

 

Anton Kreil says you will have about 3 months (or more or less) in a year in which you’ll experience drawdowns no matter what you do. How do you explain this to your investors? How do you explain this to your family?

 

When you limit a loss, you accept the fact that it won’t have any major impact on your portfolio anytime, no matter how terrible the situation may be. You can check your account history or past trading results in order to get comfort, knowing full well that your system will soon start working again because it worked in the past. You’ll be encouraged to keep on taking new signals (for you don’t know the ones that would win and recover your losses), maintaining discipline and calm.

 

To be a permanently victorious trader, you must control your loss and limit your roll-downs. It may be emotionally satisfactory to refuse to accept a mistake and ignore the use of stops, and the temptation to do silly things will balloon. In most cases, prices may go back to your entry points after harrowing periods of waiting and hope, which may be longer than normal. There’ll also be cases in which the hopes would be dashed as prices refuse to come back in your favor, going further and further against you instead. All the profits plus the capital you’ve would vanish. All market veterans acknowledge that the importance of loss control can’t be emphasized enough, because that’s the reason why over 95% of traders can’t be successful as traders.

 

On Trade2win.com, Barjon says… Perhaps all this makes it sound as though our trader’s reasoning will be spot on or that he is a fortune teller who can foresee the future. There is not such a trader. All trading is about making assumptions based on experience of what has happened in similar circumstances in the past. Those assumptions may be right or they may be wrong and from the business perspective the aim is to gain the necessary advantage when they are right and limit the damage when they are not.

 

This piece is ended by the quotes below:

 

“Our worst case scenario for the basic strategy is where the trader can lose 70 per cent of the time with a reward-risk ratio of 3:1. With these statistics the trader can still be consistently profitable. The winners take care of the losers.” – Manesh Patel

 

“The difference between top-notch winning traders and those who barely get by is the attitude they take toward losses. Trading is a tough business where setbacks and losses are commonplace. If you aren't careful, you can feel beaten, knocked down, and afraid to get back up. It may be difficult at times, but it is often necessary to forget about the past.” – Joe Ross

[sergso 10]

This is good timing for this post:)

[DbPhoenix 42]

  sergso said:

This is good timing for this post:)

 

Unfortunately, it's all theoretical, despite the use of statistics.

 

There is no reason to sacrifice outsize gains in order to reduce losses. The key here is to understand trend, trend reversal, trend interruption, trend continuation and know when to stand aside and let the market work things out.

 

As for the “Our worst case scenario for the basic strategy is where the trader can lose 70 per cent of the time with a reward-risk ratio of 3:1. With these statistics the trader can still be consistently profitable. The winners take care of the losers.”, this is peddled to beginners almost constantly, and it is dangerously incomplete. Yes, theoretically it is true. But how many traders, particularly beginners, can take 7 losers out of 10 and yet allow subsequent winners to "run"? Traders cut their profits short -- whether they're beginners or not -- because of the losses they've realized. Their fears of taking yet another loss virtually guarantees that they will cut any profits short, as well as letting future losers run because they just can't accept more losses.

 

Magee busted this postulate 70 years ago, but memories are short, and what was old becomes new again.

[zupcon 10]

If I look at my personal trading statistics, I find that I'm only making new equity highs around about 18% of the time.

 

So, in reality, 82% of the time I'm technically in drawdown, and I'm losing money, or slowly recovering money that I lost earlier.

 

What I find particularly amusing about those figures is that practically everyone who has ever seen my equity curve has accused me of fabricating the results !

 

Its a beautiful illustration of just how wildly unrealistic most people's expectations possibly are.

 

I was genuinely surprised by the comment by Anton Kriel suggesting that his students might experience drawdown in approximately 3 months of each year. I dont know Anton personally, but I am aware that he advocates trading a diversified portfolio of instruments and typically over a much longer timeframe than the typical day trader.

 

Even so, those figures seam a little over optimistic to me, if they are true, his students must be absolutely killing it.

[MightyMouse 12]

This market is a trader's paradise. A trader needs to rethink his strategy if he is experiencing drawdowns longer for than few hours with this volatility.

[wmck6167 10]

This is a great experience sharing. Thanks.

After a long period of time thinking and confusions about the market efficiency, I think when market asks you to "cooprate to lost", you had better to be lost in order to reduce the lost; if you want to win, you probably hurt more by adding more capitals.

But just what if the stocks are undervalued during drawdown, I feels that it become harder to justify. Smart and right? Probably hard to keep both. Cheers.

[wmck6167 10]

"Strategy A:

Growth: 343.80%

Drawdown: 37.45%

Monthly: 19.09%"

Some math thoughts about this performance. If you can predict the edge of drawdown for 9%, you prevent the lost and cut the lost on -3% and you also can predict the fuure stock progress and make the profit on +9%, on a delta 18% stock increased, you are super to make a 6% profit. If you are in this trading system, does mean you leverage a lot(10x). I meant you have 37.45% drawdown, you are luck enough to make around 25% narmal on this drawdown if nobody add money to this sytem. Just a thought. Cheers.

[Emily291 10]

I have often wondered why drawdowns are measured from one equity peak to another?

 

Sure, the equity curve is technically in drawdown during this period, but that's really just incidental to when trading (or investment in a fund) begins. Change the start date and the advance out of a drawdown becomes a run-up . . .

 

Are there no better ways of measuring drawdown?

 

Em

[wmck6167 10]

Here are my thought and observation. It might not be right. If the trading system is a tool to fullfill the value system, then if you can caculate the values well about an equity, then you probably will have a lot of chances to know the reasonable draw down process without knowing the details of curve and peaks. I guess and good luck.