Trading Drawdowns And How To End Them
A drawdown refers to the difference between the highest balance in a trading account and the following lowest balance.
Drawdowns are caused by losing streaks, the losses compound over a certain period and trading capital is left depleted.
Usually, drawdowns are represented as a percentage loss e.g. if the maximum balance of your account was $10 000 and you lose $2000, that is a 20% drawdown.
Here is the equity curve of the above example.
Just like a downtrend, we can see on the chart that equity declined over the given period. The drawdown period began at a high of $10 000 and ended at a low of $8000.
Why do drawdowns occur? 3 main reasons exist – Lack of an edge, poor trading psychology, and general probabilities. Let me explain each.
Lack of a trading edge
An edge means that a system will make a profit when executed over a large sample size. It does not matter how amazing a trader thinks they are. money cannot be made consistently without an edge.
If you are trading a system with a negative expectancy, then the reason for drawdown is self-explanatory. Do not assume that a certain approach has an edge in the long run, always backtest and confirm that this is the case.
Nobody should be participating in the Forex market without a positive expectancy, in this case, the drawdown will be never-ending.
Poor trading psychology
Once a trader has an edge, they need to execute with rigorous discipline. This is easier said than done, the market will constantly test your mental state and this can lead to trading errors.
You need to constantly be aware of your emotions so they do not impact your actions in the market, a great way to do this is to keep a trading journal.
Human error is often the reason behind a drawdown, finding out if this is true is rather easy. Look back on all the trades made during the drawdown period and ask yourself if all rules set out in your trading plan were followed. If not, this is the reason.
If you have an edge and have been executing it with rigorous discipline then the reasoning behind the drawdown is general probabilities. What does this mean?
Every system will encounter losses and these losing trades are distributed randomly, therefore now and then you will get a string of losing trades and your account will be in a drawdown. No need to worry though, eventually the positive expectancy will balance out the bad period.
Before continuing here is a quick example of probabilities in action – If a system has a 60% win percentage that means 40% of trades will lose money. Place 100 trades and about 40 will be losers, these 40 occur in a random order e.g. 10 losers in a row at 2% per trade equals a drawdown of 20%.
How to end a drawdown?
Safe to say all my fellow traders want to come out of a drawdown as soon as possible, here are some key points to crawl out of this hole ASAP.
1 – Identify the drawdown as early as possible
Before you can stop the bleeding, you need to see the blood. So you must have a process in place to constantly monitor your trading results and personal performance. By doing this you may notice a certain negative personal habit or a factor negatively affecting your strategy.
Noticing these evil roots and stopping them early prevents a drawdown from becoming uncontrollable. There are two main ways to stay alert.
- Keep a trading journal including your execution performance and the psychological factors influencing you at the time.
- Monitor your system’s performance and results. Some great tools automate this process for you such as Myfxbook, PsyQuation, and quality brokers such as Plus 500 offer reports to track your performance.
2 – Work on your mental toughness
Sound execution is impossible without a sound mind. Great traders are not always smarter or more talented, they simply have sound trading psychology.
What are some of the key factors that this entails?
- Being aware of your emotions and how they influence your actions.
- Creating structures so you can remain objective.
3 – Trust in the probabilities
As long as you are trading with an edge, the probabilities will eventually work in your favor and give you a profit.
Key to this is knowing the statistical performance of your system such as the win%, risk to reward, average win, and average loss. Without an idea of these metrics, you cannot gauge how your system is performing compared to the norm.
4 – Manage risk
Losing too much during a bad period can leave a trader with no capital when the probabilities switch in their favor.
Using the example from earlier if a system loses 10 trades in a row and a trader risks 2%, the result would be a 20% drawdown. Take another trader who uses the same system but risks 10% per trade, sorry for them but after that sequence of losers, there will be no money left in the account.
Trader 1 manages risk robustly, so when the probabilities balance out they will make money in the long run. Trader 2 does not give their system a sufficient sample size to make money therefore they leave the market with empty pockets. This is why risk management is so important.
Side note – If you are new to the markets, do not over-leverage. This often leads to excess risk, read What Is Leverage In Forex Trading for more on that topic.
5 – Follow your rules
Even when luck is not on your side, you need to follow your strategy with ridged discipline. Keep your trading plan on hand to guide you through the rough waters.
Congratulations on reading about this ugly topic. Forex trading is not all sunshine and roses so it is important to manage ourselves and our actions.
Always trade in your own best interest.