How to recover from taking a heavy loss

Oct 16 • Between the lines • 2202 Views • Comments Off on How to recover from taking a heavy loss

heavy-weightsFrom the outset of this article there would be little point in stating the obvious; that no trader, sticking to their bullet proof trading plan, should ever take a heavy loss. We know traders should limit their risk per trade to no more than 2%, their loss per day should be limited to 4%, and their loss limit per week 6%. Their drawdown, before stopping trading to completely re-evaluate where they may be going wrong, should be limited to perhaps 15%.

Whilst we’ve accidentally listed a very simple list of basic money management rules there we know that, from time to time, new traders fail to stick to their rules, or as poker players refer to it, they go ‘on tilt’ in an attempt to win back the losses they’ve made. Similarly more experienced traders, who have perhaps enjoyed early success, will fail to create and or stick to a plan, believing instead that they can bypass that detail and trade on their wits and judgement.

There is no point in us being judgmental in this article, we’re attempting to illustrate how traders, who’ve veered from what we’d consider to be good trading practice, can potentially recover from a major loss. We’re going to use the arbitrary sum of a 30% account loss as our line in the sand, the point at which the trader needs to down tools, walk away from the monitor/s, and re-evaluate their whole approach to trading.

It’s important to deal with the bad news immediately; it’s going to take some time to recover these losses. No matter how quickly the losses were accrued the time taken to recover will be significant, and therein lies the first lesson the novice trader should take on board; “if the recovery may take weeks. shouldn’t the original account growth I was targetting also take weeks?” Yes is the answer. Account growth should be slow not spectacular. The equity curve on your trade ‘blotter’ should look smooth over a period of a year and not display ‘zig zag’ patterns over a much shorter period.

There has to be a point at which the trader decides “enough is enough”, our 30% trading circuit breaker is a reasonable figure to work with and immediately traders will recognise that if risking 2% for a potential 1:1 risk reward then the recouping of the loss could take approximately 15 wins in series. That continuous winning streak is unlikely to happen and perhaps belongs in the realms of fantasy that got our trader into their major loss in the first instance.

 

What we need to do is behave similar to a corporate rescue team.

In many of our previous articles we stress how important it is to treat your solo trading career as a small business. Imagine if a reasonably sized company was suffering continual losses, so much so that its banks, creditors and the directors employed a team of management consultants to establish if there was any hope to rescue the business and put it back on a firmer footing. They’d initially investigate the business thoroughly by way of a forensic audit. Then they’d establish a plan with targets in order to resuscitate it. They’d get that plan approved by all parties and the business would then begin to trade again. The first milestone would probably be getting the company to stop hemorrhaging losses, then moving (back) to a break even situation. In many ways that scenario is similar to how we’ll conduct our own small corporate rescue; we’ll set a target, hopefully not too far into the future, by which time we should be back to break even after identifying why we’re making losses and putting a stop to them.

We’ve provided a simple table here that illustrates just how limiting losses to no more than 2% can still leave traders in what we’d term a ‘recovery position’. Using 2% a series of ten losing trades (risking 2% on the diminishing balance each time) will result in a loss of 16.65%, and a series of ten consecutive losses would be what we’d term an ‘outlier’ in a set of data. But if risking 10% on each trade we could see a loss of 65.11%.

Starting balance €1000

Balance after 2% losses.           Balance after 10% losses

Loss 1.- 980.                                Loss 1. – 900

Loss 2.- 960.                                Loss 2. – 810

Loss 3.- 941.                                Loss 3. – 729

Loss 4.- 922.                                Loss 4. – 656

Loss 5.- 903.                                Loss 5. – 590

Loss 6.- 885.                                Loss 6. – 531

Loss 7.- 868.                                Loss 7. – 477

Loss 8.- 850.                                Loss 8. – 429

Loss 9.- 833.                                Loss 9. – 387

Loss10.-816.                                Loss 10. 348

Now if we turn this table and its results on its head we can perform a rough calculation as to how many trades it will take us to get back to a break even situation from the 30% loss by risking the 2% per trade and making some reasonable presumptions regarding probabilities. Not only can we make reasonable presumptions regarding the amount of trades to reach break even, but also the length of time required.

If we were to enjoy 15 straight winners on a 1:1 risk reward, by risking 2% we could expect to reach our 30% recovery inside 8 trading days if limiting ourselves to two trades a day. However, as previously stated, 15 wins in series is very unlikely and we shouldn’t aim for it.

A more reasonable expectation would be to lose circa 50% of the 30 trades, but have a reward to risk of 1:2, we could then expect our recovery to take roughly three trading weeks. Now despite the fact that impatience, lack of trading discipline and not sticking to a trading plan will have caused the trader to originally lose 30% of their account, to then recover from such a dire position, in three weeks, by accepting that risk should be limited to a sensible level and playing out the probabilities, is a very quick turnaround, a turnaround that our corporate rescue team would be delighted with.

Now bear in mind that our recovery calculation is only a rough estimation and we’ve deliberately left it as such as it illustrates that (in trading) nothing ever goes completely to plan, particularly with the events involved in trading that we can’t control. For example our losses in our recovery may be kept smaller by the effective use of stops, our winners will probably not hit the 1:2 ratio on each trade, but what we’ve laid out is a recovery strategy that can work in a remarkably short period of time.

For those impatient traders in our community, who have lost circa 30% in a short period of time, an approximate three week recovery by following a simple plan, might appear at face value a long period of time. However, in terms of trading recovery it’s an incredibly short period and should highlight to inexperienced traders that no matter what the losing situation you find yourself in recovery is possible if you stick to the new set of rules.

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