“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
