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Home » Business And Finance Articles » Understanding And Dealing With Drawdowns

Understanding and Dealing with Drawdowns

We all have it and go through it one time or another and will continue to go through it. For others, drawdowns are more common than profit run-ups. Or worse, each drawdown is worse than the last. It's a never-ending cycle where these holes appear in our equity charts or account statement. How does a trader go about understanding and coping with them?

The main problem with drawdowns is that the majority of the traders don't know they exist and have ignored them. They have only calculated how much they will make and what they will do with that money earned. But little thought is given to how much each trade would bring and by how many losing trades it takes to wipe out the account. Those without a trading plan or a strategy will have no idea what their expected drawdowns will be. Only after they lose it all did they realize they need a plan to deal with losses.

First is to formulate a strategy and test and demo trade that strategy in a consistent way. Once that's done, start demo trading and begin keeping record and calculate all the losses, wins percentage plus countless other statistics to give an idea how the strategy fares. These demo accounts are offered free by many brokers. Among all of these ready-made calculations from the trades, there is a calculation for accumulated losses as well as average loss per trade. These two formulas show a strategy's likeliness to losing periods and by how much, either in terms of consecutive losing trades or the loss since the highest equity amount. When knowing this in advance, we can expect it in the near future and not be tempted to doubt and even abandon the strategy when in fact it's a profitable system in the long run. Most will never know because they cannot look beyond the current drawdown as part of the overall strategy. This is why testing and reviewing the strategy performance results is such an important part of trading, not just trading. This is where mechanical traders have an edge by following through a process of taking an idea into a final live trading phase.

Drawdown happens to everyone and can happen at anytime. Whether it's caused by the strategy itself or by the trader's own psychological and emotional issues, drawdowns is a fact of trading life. The only way to deal with it is to prepare for it and if possible, identify it and keep it to the minimum. This can be accomplished by reducing the size of the position, trade less or be more vigilant and cautious on each trade.

Drawdowns are the biggest reason why most people cannot survive trading because of the emotional stress that comes with them. These are moments when the trader is truly tested, some overcoming it by continuing and staying with the strategy until the drawdown in finished. Most, however, come undone by doubting their system and lose self-confidence as a trader. Eventually, these traders move on to other systems that will eventually go with their own drawdowns, which spiral to more losses, losing more equity. It's a vicious cycle where the biggest damage is not monetary but psychological. Eventually, these traders cannot handle the stress and quit.

Having explained the consequences of a drawdown, this is why it is so important to concentrate on finding the historical drawdowns associated with the strategy before trading them. This will prepare the trader to expect and deal better with the losing streak. When a person expects and prepares for the worst, he usually comes out feeling better mentally, especially when the result is not as bad as expected.

This mental state has to be nurtured and watched constantly during this period. More important than losing money is the loss of objectivity and confidence. So when this period does arrive, monitor and pay closer attention to each action and mental thought. In doing so, it will lead the trader out of the drawdowns with confidence intact.

And here is another random article you might be interested in...

Getting Results from Your Writing & Speaking

When we communicate, we usually want something to happen. We want results. And, when we're conscious of results, we're seeking effective communication.

To put it another way, the effectiveness of communication can be measured by the responses it gets. It's not measured by how well we wrote or how eloquently we spoke, although those can help us get the responses we want.

Good writing and speaking help us get a response because they help get the message across. As I've argued in my book, A Manager's Guide to Newsletters, a newsletter that doesn't get read cannot get a response from readers.

So, writing, designing, speaking, and all those other creative activities matter. But, in the end, responses are what count, and effectiveness means getting the responses we want.

That's true for all types of communication, and not just marketing campaigns. Managers who send messages to employees, for example, want employees to respond in a particular way. Maybe they want the employees to do something differently, or maybe they want to reinforce existing behaviors.

For a couple of employee newsletters I published, effectiveness meant greater awareness of health and safety issues. If the newsletter worked, then they should have helped reduce the number of plant accidents and helped employees lead healthier lifestyles.

One more point: Effectiveness cannot be achieved without articulated objectives. As the old adage goes, "If you don't know where you're going, any road with do." Or, as the inimitable Yogi Berra put it, "If you don't know where you are going... You might end up someplace else."

With that, let's create a quick and easy checklist that takes us through the basic steps required for effective communication:

1. What is your objective, what do you want to happen? Do you want more sales, reduced employee turnover, renewals by members? Be specific about your objectives, and if you can attach time and dollar values to them so much the better.

2. What response of readers or listeners is necessary? What action should they take? What thoughts do you want them to keep in their minds? Do you want to reinforce existing thinking or behaviors? What do they need to do in terms of your objective?

3. Why would they respond to your message? It's all very well for you to have objectives, but you'll also have to offer something that provides value in their terms. Think of commercial broadcasting, which combines free entertainment with advertising messages.

4. What message content will motivate them to act? What subjects will provide that value to them?

5. How will you present that content? You can entertain, inform, consult, challenge, solve problems, and more.

6. How often will you have to repeat the message? In many cases, you'll need to make multiple contacts to get the response you want. Stockbrokers making sales calls, for example, figure on an average of five to seven contacts before a prospect becomes a potential client.

7. If you quantified your objectives, does the value of meeting the objective exceed the cost of communicating? In a marketing context, for example, how many sales do you have to make to pay the cost of your advertising campaign?

Going through these steps will start us on the right foot, because it pushes us to think about responses. And, when we're focused on responses, we're much more likely to communicate effectively.