Becoming a Better Trader – How to Handle a Drawdown

In this webinar, we discussed the inevitable drawdown (in fact, your account spends a large swath of time underwater), and how to handle both the ‘normal’ variety which occur regularly, and more importantly, the ones which fall under the ‘problematic’ category.

We understand the difficulties of trading, which is why we’ve put together a variety of guides designed to help traders of all experience levels.

Drawdowns are a natural part of trading…

Part of trading is losing, that’s just a fact that everyone must accept straight away. So, naturally, experiencing drawdowns is also going to be a fact of the business one must accept. As you can see below, a trader spends a large amount of time in a drawdown, even during extended periods of profitability.

A lot of time is spent drawing down even during periods of profitability

Difference between a ‘normal’ and ‘problematic’ drawdown

There are a couple of different types of drawdowns – ‘normal’ and the menacing ones considered to be ‘problematic’. A normal drawdown is one which results from the ebb and flow of trading and a function of the business. During these periods your losses are well controlled and it doesn’t take much to return to setting a new high in your account balance. These are not to be overly concerned with as long as you are doing what is right according to your trading plan.

But these can turn problematic, where the losses begin to pile up to the point of causing distress. These are almost always a result of poor trading behavior. It is during these times that is it becomes extremely important in how one handles the drawdown, as serious mistakes mount into damaging losses of both actual and mental capital.

Whether you are a new trader building a foundation or an experienced trader struggling (happens to the best), here are 4 ideas for Building Confidence in Trading

Handling ‘normal’ drawdowns

First off, drawdowns are a simply a function of probabilities and an uneven expectation in returns. Results tend to cluster. For example, you could have a 50%-win rate, but that doesn’t mean you won’t run into a string of losers over time just as you will run into a string of winners. It’s just as a result of probabilities, clustering (think of flipping a coin).

Then there are other manageable drawdowns which stem from other areas such as game-plan execution and market conditions. Handling a drawdown really boils down to understanding that you might not be trading particularly well or that market conditions may not be conducive for your strategy, and that you may need to lay off a bit. For example, a trader trying to trade breakouts during a range-bound market will struggle and need to acknowledge this by taking a step back. Often times, drawdowns involve a combination of difficult trading conditions and minor errors.

In any event, we can’t be perfect and is fine as long as you recognize and acknowledge (self-awareness) the situation. It’s always a prudent decision to reduce your trading size if uncomfortable with what is happening. The old saying, “when in doubt, get out”, is always applicable to trading. Having the discipline to stick to this principle, alone, can go a long way towards halting a drawdown. This is a good time to check yourself and see if you are taking proper trades and handling risk appropriately. Whether you are trading well or poorly, it is a good idea to consistently review your trading and make sure you are acting in accordance to what you set out to do.

One of the most common and clear-cut reasons for poor results is over-trading and poor risk management. Those are the first two areas to begin taking a look at when things aren’t going your way, because these you have control over and can be remedied right away.

Bottom line, it’s important to have self awareness as to what is driving your trading results and then address any issues which might need to be handled.

Handling ‘problematic’ drawdowns

When the losses get uncomfortable, ‘out of control’ so to speak – this is when you have to take extra care as this is when a drawdown has gone from the ‘normal’ to ‘problematic’ category. The last thing you want to do is compound an already difficult situation, so the very first thing to do when you recognize that you’ve taken it too far is to ‘get out of the fire’. Stop trading for a period of time, a few days or longer if need be (weekends don’t count).

Closing out existing positions and taking a little time off will not only stop the bleeding, but do your psyche wonders. Even though the losses are still there, this first step will help bring immediate relief. It can be difficult to do the first time around, but once you do it you will recognize later on when to do it sooner and thank yourself for having the discipline to walk away and stop fighting. This is one of those times where working harder will work against you.

Once you’ve had some time to recuperate, then start looking at what actions got you into a sticky position in the first place. You will likely already have an idea as to what got there, but looking at your trade history, journal, and any other records of your trading will help you identify most accurately what went wrong. Often times, it boils down to poor risk management and over-trading. That is, trading with too much size, poor risk/reward, and taking too many low-quality trade set-ups.

Once you’ve identified the culprit (often times more than one), and have a fix in place, you should resume trading with minimal size; trading with no more than 50% of max size, 25% or less is even better. The idea here is not to make back all your losses at once, but to restore your confidence and get moving in the right direction.

Reducing the risk of a drawdown, preventing problematic ones

Obviously, we want to avoid material drawdowns as much as possible, but how is this possible? We can’t control market conditions, but we can control our own process of trading. We’ve talked about this at length before, but utilizing a checklist, whether mental or physical, can be an excellent way to keep you on track to making those trades which fit within your game-plan. Tighter risk management parameters will obviously mean it will take longer for losses to pile up. Bottom line, we have to be vigilant about taking only those trades within our game-plan and doing so with risk we can handle.

If you are experiencing a personal issue, it’s a good idea to lay low until you’ve resolved those matters. We all have things going on in our lives from time to time, acknowledging that the market isn’t the place to look for solace will prevent you from compounding an already difficult situation. Step away, resolve your other issues first. Remember, the market will always be there when you’re ready to return.

For the full conversation, please see the video above…

Enjoy the video? Join Paul or any of the team’s analysts live each week for webinars covering analysis, fundamental events, and education.

Past recordings you might be interested in:Creating a Trading Plan; Handling Drawdowns; Risk Management; Analysis, keeping it simple; 6 Mistakes Traders Make; Focusing on the Process; Building Consistency; Classic Chart Patterns, Part I; Classic Chart Patterns, Part II

—Written by Paul Robinson, Market Analyst