Why Do Drawdowns Exist And How To Deal With Them Efficiently

Drawdowns and losing streaks happen even to the best traders and they often result in an avoidable downward spiral causing traders to lose not only their self-awareness, but also much more capital than necessary. Understanding why there are drawdowns and knowing how to deal with such challenging situations, helps traders to survive and even progress in the face of losing streaks.

Short-term vs. long-term concepts of trading performance

The misconception about the concept ‘winrate’ and how it influences your performance often causes confusion and wrong beliefs. A trader with a 60% winrate has a chance of realizing four consecutive losing trades of 2.5%. Although this sounds like a low probability, if you only take one trade per day, you will encounter such a losing streak multiple times per year.

Tip 1: Don’t underestimate the likelihood of losing streaks and drawdowns. They are inevitable and will happen to you frequently over the course of regular trading.

Changing market conditions pose challenges for trading systems

Next, it is important to understand that drawdowns and losing streaks do not happen because a trader has limited abilities or because a trading system suddenly ‘stopped working’. Financial markets are constantly alternating and evolving, and the economic, financial and political environment change continuously as well. All of these factors impact how prices move, how volatility manifests and, finally, how your trading method performs.

The two screenshots below illustrate how financial markets go through different phases regularly. On the left, the VIX (volatility index) shows how different certain periods can be; whereas you hardly see any volatility in some weeks, volatility increases significantly in other periods. The right image shows the daily prices of Wheat futures. This price chart further emphasizes the ever changing nature of financial markets; periods of clean and smooth trends alternate with range-bound price behavior constantly.

Fluctuating and changing market conditions pose challenges for trading methods. When volatility picks up, methods with tight stop loss orders will experience more losses. During times of low volatility, price targets could be too far away. Strong, trending markets can be challenging for support and resistance traders and range-bound markets are a nightmare for trend and swing traders.  Those are just a few examples why different market conditions can result in more frequent losses. And although the different stages of price behavior are very obvious after the fact, without the benefit of hindsight, it is virtually impossible to always accurately alternate your trading approach.

The placement of contingent orders by you or broker, such as a “stop-loss” or “stop-limit” order, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders.

Tip 2: Financial markets are always changing and evolving. Different market conditions pose challenges for trading systems. Accept that your method cannot be correct all of the time. It’s the nature of the business.

VIX Futures Chart

Avoid these 2 mistakes during drawdowns

It is normal that traders ask themselves “What am I doing wrong?” when they enter a losing streak and then try to outsmart the market and their trading strategy. However, there are two common mistakes that usually result in unnecessarily large losses and an extension of their losing streak.

1) Increasing position size during periods of losses

“Trying to trade during a losing streak is emotionally devastating. Trying to play “catch up” is lethal.”
– Ed Seykota

Increasing position size during losing streaks is a big mistake. There is no way of knowing when the streak will end and, even more importantly, when emotional problems and impulsive trading influences your decisions, it can be fatal for your trading.

Tip 3: Do not depart from your regular approach. Anything that signals a change from your usual trading should be avoided during drawdowns.

2) Making adjustments to your trading method

A big misconception is that traders believe that their trading method suddenly stopped working and that they have to make changes to win again. Often, traders change the settings of their indicators, add new trading tools or use different approaches to their stop loss and take profit placement without ever having tested them before. Needless to say, such premature actions only make the problem worse.

Tip 4: Stick to what has worked before. Believe in your system and your abilities. Changing your approach resets your learning curve and destroys the long-term expectancy of your system.

How to judge drawdowns

Not all winning trades are good and not all losers are bad, and understanding how to interpret your results is vital for success in trading. Always ask yourself the following questions:

• Have I respected my trading rules? Did I violate them at one point?
• Did I stick to my trading plan? Did I jump the gun?
• Could the loss have been avoided with the information available?

If you can rule out the possibility that you, as a trader, did something wrong and are the cause for a loss, then you should accept that drawdowns are a a natural process of the markets, trading and as such, your trading psychology and discipline should stay in tact. 

On the other hand, if your winning trade is the result of ‘luck’ because you violated your rules, you should pay close attention to such patterns in your trading behavior.

Tip 5: Don’t exclusively judge your trades and your abilities by the outcome of your trades.

Improving during losing streaks

Drawdowns are excellent opportunities for you to analyze your game and to find out why things are not playing out; instead of giving in to problem thinking, analyze your strengths. Identify the instruments, timeframes, stop loss and take profit placement approaches, trade management, money and risk management techniques that have the best historical performance for you. But keep in mind, do not make impulsive alternations to your trading strategy, just do more of what has worked best for you previously. Even the longest losing streak will end eventually.

Please be advised that trading futures and options involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results. This matter is intended as a solicitation to trade