What is a Drawdown in Trading and How to Handle It

In this lesson, we discussed the unavoidable and avoidable drawdowns that traders go through. Losing is part of trading, and there will be plenty of losing periods over the course of a career, but how you manage them can be the difference between finding success and even possibly ending your career in ruin.

There are two types of drawdowns – ‘Normal’ and ‘Problematic’.

Normal drawdowns

Normal drawdown occur as a natural function of the ups and downs of trading related to market conditions, small deviations away from our trading plans, or a little of both. These aren’t perceived as threatening, nor should they be, but must be managed to avoid becoming problematic drawdowns that hurt not only our trading accounts, but psyche as well.

There are measures we can take to manage normal drawdowns to prevent from digging a hole that sets you back for prolonged periods of time, or worse. It’s not just about money management, but making sure you are following a repeatable process that involves trading in a manner consistent with your trading plan.

The first thing you want to do when experiencing a drawdown that isn’t problematic, is perform a self-check and make sure you are indeed sticking to the plan and processes in place that you have identified as part of a successful trading plan. If you are following your plan, then it could be market conditions aren’t conducive to your particular strategy at the time.

Your strategy(s) won’t work all the time, there will be ebbs in how successful it is in different market conditions. This can make sticking to the plan challenging, but it is important that you stay the course.

You may want to consider reducing your trading size even if you aren’t losing a lot of money, because it can not only help keep drawdowns manageable but allow you trade more objectively since nothing meaningful is on the line.

Remember, you always want to protect not only your capital, but your confidence.

Problematic drawdowns

Problematic drawdown happen, but should be infrequent, and certainly shouldn’t lead to a catastrophic drawdown. Problematic drawdowns aren’t the end of the world, even if at the time it may feel like it. When handled properly, a trader can fast-track themselves back to a confident state that allows them to make back losses and move forward.

If undergoing a really rough period where you have hit a threshold of maximum pain, first thing is first – get out of the fire. Cut all trading exposure and flatten out your account. Just by stopping the bleeding you will immediately feel a sense of relief.

Take some time away from the markets to decompress. This can be tough to do as the competitor in you may compel you to fight through it, but some time away will help not only provide necessary stress release but give you some perspective.

The next step is identify the cause(s) of the drawdown. It is often a function of multiple problems occurring at once, so it is important that once you identify what is going wrong you don’t try to fix everything at once. This will only lead to further frustration and more losses.

Instead, start with the most important problems that might be plaguing you. Often times large drawdowns stem from a loss of control on risk management. All good trading begins and ends with proper risk management. It might be that you are trading too large or that you are not sticking to stop-losses.

It could be that you are over-trading, or trading impulsively. Lots of traders can identify good trade set-ups, but lack the discipline to only take those trades which qualify as “good”. This over-trading is a major killer to success as low quality set-ups eat away at profits made on sound trades. Over-trading must be reined in.

One way to do this is to create a check-list where you must check off all the boxes of a good set-up before entering. It will take discipline to stick to this, but is a way to help hold yourself accountable.

There are of course a number of other issues, including personal ones, that could be hurting your trading, but generally speaking you want to a) identify the problem and b) put in place a fix before resuming trading again.

Once you’ve put a fix in place and have a plan in hand for getting back on track you want to come back slowly. Your objective is to make good trades and restore your confidence, build back up the self-efficacy that you lost. If you do this, then you can position yourself to make back the monetary losses. But if you try to make all the losses back quickly, then you are creating a recipe for disaster.

Summary:

Accept that losing is part of the game

There are normal and problematic drawdowns, know the difference

If a normal drawdown, stick to your guns (consider size reduction)

If a problematic drawdown – get out of the fire, reassess, come back slowly

Avoid problematic drawdowns by careful planning ahead of time (use a circuit breaker)

For full details, please see the video above. Looking for trading ideas? Check out the DailyFX Trading Guides page.

—Written by Paul Robinson, Market Analyst

You can follow Paul on Twitter at @PaulRobinonFX.