10-tips-to-potentially-help-you-survive-the-next-drawdown

Drawdown is a Reality of Every Trader

Being able to deal with and understand drawdowns are among the most important concepts in trading and in the life of a futures trader. Misinterpreting drawdowns lead to wrong assumptions and decisions that not only may result in larger drawdowns, but can even mean the “end” of a trading account.

Conventional drawdown parameters and risk metrics such as the Sharpe and Sortino ratio may add value when it comes to understanding one’s own performance. However, we think that on their own, they are not sufficient to understand drawdowns and you may require the understanding of additional concepts to fully appreciate the positive and the negative of your own style, and/or the analysis of an automated system or a managed account run by a commodity trading adviser.

A good starting point is the so-called ‘peak to valley’ drawdown metrics where a trader analyses the largest drawdown periods that the account spends below a high watermark. However, instead of just focusing on the largest absolute drawdown, it is recommended to also check for annual, semi-annual and quarterly ‘peak to valley’ drawdowns so that you get a feeling as to what to expect during shorter and longer time periods. The purpose here is to know your performance, so that the next time you enter a drawdown period, you are better prepared and you know roughly what to expect and what is “normal” when it comes to your own method.

Next, you should look at the drawdown duration and how long your typical drawdown lasts on average. The time component is an important metric because financial markets go through the same cycles over and over again and, thus, trading systems will naturally have better and more challenging periods.

Charts courtesy of iSystems

In the context of drawdown-duration, it can useful to knowing under which market conditions your trading method performs best. Thus, a trader who knows the current market environment can better understand his drawdowns; all trading systems undergo those cycles and you just have to push through the more challenging times to make it to the next market cycle that may favors you system and method.

At the same time, a trader who understands how long his average drawdowns last from a time perspective, can easily see when markets shift back into his favor and then also adjust his risk management accordingly – we will cover that later.

Finally, a trader who knows his average drawdown duration in trade numbers can adjust his position sizing in a way that allows him to minimize performance drawdowns. Here, it is especially important to know the average and the maximum number of consecutive losing trades your system produces.

Whereas most trading literature suggests keeping risk constant during drawdowns (sometimes you will even see recommendations to increase the size) because it will, theoretically, allow you to get out of the drawdown faster, this is almost never what a trader should be doing.

Manage your drawdowns like a Professional Trader

The main problem a trader faces during a drawdown is almost never the loss of monetary capital, but the loss of emotional capital. A drawdown can weigh heavily on the psychology of a trader and when frustration, lack motivation and helplessness set in, traders often abandon their trading rules and become undisciplined which then leads, of course, to even worse drawdowns.

A trader who experiences emotional problems during a drawdown also has little use for the previously discussed statistical based drawdown metrics since his greatest challenge is usually to pick himself up. Knowing that a drawdown will end is good but once a trader hast lost his emotional capital, rational thinking is hard to follow.

In summery:

Drawdown is simply the pain period you must endure while your systems does not have positive expectancy. You measure drawdowns between your highest performance peak and the lowest equity. However, if you recover from the drawdown, and reach new equity highs, you can measure your previous equity high to your new equity high. s mentioned above, this will give you a perspective how long it took market conditions to change to match your trading method.

Time is also a measure of drawdown. Traders and investor could periodically be in more pain over the length of drawdown than the actual financial loss occurring.