How to Handle a Drawdown

Losing Streaks

The typical drawdown. Google Images

In the simplest possible terms, a drawdown represents a decline in the value of an investment portfolio. There are three components of the drawdown: the duration, the frequency, and the size. The size (i.e., the sum lost) is measured from the previous account high to the account low. The drawdown ends when the account value surpass the previous high.  

No one earns a profit on every trade. Few earn money month after month without interruption.

Occasionally losing money over a short time span is an acceptable part of every winning trader's playbook. However, the successful trader understands what caused the drawdown and how to minimize such events in the future. 

When dealing with probability -- as we do when trading in the stock market -- trades do not always go your way. Traders who lose money due to a lack of discipline may have difficulty in knowing how to handle future losing streaks. If you are a trader who is never satisfied with the size of your profits and hold positions in an effort to earn every possible penny from the trade; if you are never willing to exit a losing trade; if you have a trade plan but refuse to follow it... then you have a serious problem with discipline. Such traders tend to have little control over how much money they earn or lose because they depend too much on luck. When dealing with statistics, luck runs both ways.

If all your trades come with a 90% probability of earning a profit, you can expect the next three trades will all be winners only 72% of the time. in other words, there is a 28% chance than at least one of the next three trades will lose money.

Lack of control over the size of your losses results in frequent and sizable drawdowns.

If your personality is such that be disciplined is too difficult, then you must adopt a strategy that does not require too much discipline. For example, your new strategy could be simply buying index funds every month or every three months and never being tempted to time the markets. For you, buy and hold is probably as good as you can do.

If your methods are well thought out and you devise good trade plans and actually follow those plans; if your trading losses are minimized by careful risk management techniques; if your losing streak occurs because of the natural ebb and flow (i,e., no strategy works all the time) of the markets,  then there is every reason to believe that you will be able to handle drawdowns.

It is important for every trader to make an honest evaluation of trades that result in money being lost. In my opinion, it is always easy to make money in the markets (i.e., some of your trades will be profitable) -- but careless traders allow losses to overwhelm those profits with the inevitable result that the trader loses his/her trading account. My advice is to keep records of how often these losing streaks occur, and especially, how much of your account is lost during such drawdowns.

These periods of unprofitability will define your trading future.

   Small, infrequent drawdowns = success.

   Large, frequent drawdowns = unhappiness.

For the well-financed professional trader, the drawdown, is discouraging, but not deadly -- unless that trader is undisciplined and refuses to take corrective action to stop losing streaks. The pro depends on his/her trading as a means for earning a living. When losing money becomes the norm, when drawdowns continue too long, the trader probably cannot stay in business. And make no mistake -- trading is a business. 

For "regular folks" who trade/invest, the concept of being aware of the size and frequency of money-losing streaks is just as important.  If investing is your path towards financial security, then good planning, careful risk management and being disciplined are the keys to your success.

If your trading is losing money month after month or if you suffer a very significant loss (perhaps 30 to 40% of your trading account), then it is reasonable to conclude that you should be doing things differently.