Hanging tough, how to cope emotionally with that inevitable large drawdown and how we decide what that drawdown should be

Nov 26 • Between the lines • 1783 Views • Comments Off on Hanging tough, how to cope emotionally with that inevitable large drawdown and how we decide what that drawdown should be

shutterstock_81358690One of the most important subjects, that new traders fail to address in their trading plan, is the element of drawdown. There are several reasons for this but we’ll highlight just two. Firstly, it could be that the overt optimism new traders experience, shortly after finding the industry, prevents them from accepting that losses are an inevitable part of doing business (in this business) as are winners. Secondly, it could be that the importance of the trading plan has been completely overlooked.

Accepting that losses will happen (perhaps in equal amounts to winners) and plotting for a series of losses leading to a significant drawdown, is an essential ingredient that must be addressed in the trading plan. The impact of that drawdown can be limited emotionally if our trader has planned for and has expected to endure a drawdown at some stage of their fledging trading career.

The 15% drawdown trading folklore

There are many figures published on various trading forums, or in articles on trading websites, with regards to what market commentators and traders would deem acceptable drawdowns. The most quoted figure appears to be 15%. This figure has somehow gathered support to become part of ‘trading folklore’ when in reality it’s simply a throwaway level that has no relevance to an individual trader’s plan.

As previously mentioned a drawdown limit should be contained in the trading plan and should come under one of the most critical subjects of that plan, that of “overall risk”. And in relation to the title of the article, “how to cope emotionally with a drawdown”, what traders will quickly discover is that if they’ve committed that drawdown to their plan it makes facing up to it a lot easier if and when it inevitably occurs. It’s as if by committing it to the plan our trader is in many ways anticipating that at some stage they may face the drawdown and are steeled in preparation.

Why a 15% drawdown for the majority of traders is too great

As we’ve mentioned earlier in the article the 15% figure appears to have become accepted as trading folklore when in reality a drawdown level is as personal as the trading plan containing all the hopes, fears and metrics of an individual trader’s ambitions. But for the majority of traders a 15% drawdown is far too drastic a level and should be immediately dismissed as unworkable in relation to our trader’s overall welfare and emotionally stability.

Inexperienced traders should not be risking more than 1% per trade, if risking 1% they’d need a close on 15 trade losing streak in order to breach the 15% level, assuming they’re risking 1% of the original capital on each trade. If reducing risk proportionately to the account level left after each trade then the losses in series needed to breach the drawdown would be even greater. If our trader was enduring twice as many losses as winners in their losing streak they might need circa 22 trades in order to breach their drawdown level. That figure (15%) represents too much of a loss in order to establish if the current method and overall strategy needs adjusting but the amount of trades is considered a reasonable amount on which to make judgments as to the efficiency of the trading system.

Adjusting your drawdown to your emotional drawdown

Rather than adopting the accepted wisdom that 15% is acceptable, traders should take a moment to ask themselves what they genuinely consider a drawdown that would hurt. What combined loss would cause emotional pain; 5%, 10%? Once our trader has decided what their real personal tolerance is they can then adjust all their other trading parameters accordingly.

For example they may decide that 7% is their limit before changing their overall method. Therefore 1% risk per trade would be too much, given that 7 losers in series is not that uncommon and a perhaps 10 trade run of 3 winners and seven losers is not unusual, neither is it enough trades to judge our overall strategy by. Therefore our trader needs to adjust their risk per trade to 0.5%, this should result in approximately 22 trades of an overall losing strategy to determine if it’s time to end the method and reconsider. 22 swing trades, on one security such as EUR/USD would (based on recent history) take over 2 months to fully execute. And it’s on this subject that we reach a very important conclusion with regards to our overall emotions and emotional control over our trading…

We’ve completely take control over our; trading, our emotions and our trading plan by deciding that our drawdown level of circa 7% is the limit we’re prepared to suffer. And at that instant we’re making one of the most important decisions in our plan. Experienced traders will continually stress how risk is the key to success in this industry; control the risk, control your losses and you’ll control your emotions as if by accident.

Knowing that, as set out in our example, your current strategy might take two months of losers and winners to prove or disprove whether not your strategy is working, offers unbeatable levels of self-control and emotional control and time you’ll experience will give you ample opportunity to thoroughly examine your overall method and strategy as the trades unfold.

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