What Every Trader Must Know About Drawdowns

What Every Trader Must Know About Drawdowns

“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).

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 run 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 are triggered and take profit levels are hardly reached. The few take profit levels that are reached are too few to recover the too many stops that are triggered. You open many trades and they move in your favour by a few or several pips and then turn negative, hitting your stop. For days, weeks, or months, false breakouts are not a curiosity and sustained trending movement are 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 will reap the benefits of doing the rights things.


Soon, a time comes when the situation changes 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 through 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 had 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 their religion, without telling them the reality that religious people are not immune from suffering – 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 in the end.
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 the majority of traders fail. Your ability to deal with drawdowns successfully is the greatest determinant of the end game and is your ability to enjoy a long-lasting career.

The smaller a loss is, the easier it is to recover. The bigger a loss is, the more difficult it is 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 will be flat (you won’t 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 will then eventually recover. Flat and drawdown periods 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 have imagined the worst-case scenario. With that kind of mindset, you’ll realise 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 will be dashed and your courage will evaporate. The frustration can even become more intense, especially if you live in a country where you have to generate your own electricity and fuel is extremely scarce and expensive.

What Good Traders Experience
I remember what happened to me in 2011. I was making good profits for about four months: up to 30% (6,000 pips). Then suddenly, the market conditions changed and I was having loss after loss. I kept on managing my risk, being faithful to the system I used. The losing periods lasted for about three months and I went down from 30% pips to 15%, and suddenly… the market conditions became favourable 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 an 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 gain 15% 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 three 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 reassure yourself, 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 losses and limit your roll-downs. It may be emotionally satisfying 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 will also be cases in which the hopes are dashed as prices refuse to come back in your favour, going further and further against you instead. All the profits plus the capital you have can 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, 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 no such 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 chapter 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

 

This article was taken from the book titled: Unlock Your Potential with the Realities of Trading

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Author : Azeez Mustapha

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Azeez Mustapha is an experienced author, trader, markets analyst, signals strategist, and funds-manager.