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Wednesday, November 14, 2007

Money Management: Drawdown

Unless you are God, no one has any idea what will happen in the markets tomorrow. We cannot predict accurately. The best thing we try to do, is what any business person does. Try to look and see what the current market is telling us, and what might be on the horizon in the future. Then identify low-risk, hi-reward possibilities.

And sometimes. Sometimes we get it wrong.

Our reaction to that can be very interesting. Often, we rail against it. Our ego is bruised. We are convinced that we knew the direction the market was going to take. When in fact, nothing could be further from the truth. We don't know. We never did. Again, what is our business? Try to look and see what the current market is telling us, and what might be on the horizon in the future. Then identify low-risk, high reward possibilities. That's it.

Now, if we have applied the above topics to our trading? Risk Analysis? Reward Analysis? Proper Trade / Investment management? Then our 'bruised' ego will be much less. We won't need that trade to win, because it only represents 3% of our total account. That's all. No biggie. It's only the undercapitalized investor / trader that needs a particular trade to be a winner. Thus, when it's only 3% - we can see the bigger picture. The bigger picture, is the systems performance, not the individual trade.

Having a trade move against you? Or having a series of losing trades? That's drawdown, and it is a fact of life. Drawdown is a reduction in account equity from a trade or series of trades. As I said, it's a fact of trading. Because none of us are god. We may not like the fact that we can't predict market direction correctly 100% of the time, that our trade plan may have been off, etc. But there it is. We're going to have the market turn against us at times while we are within the trade. And we're going to have the market stop us out of trades at times. Fact of life.

What do we do?

DRAWDOWN TRACKING: It is vital that you track your drawdown. There are two types of drawdown we need to track. Inter-trade Drawdown - which means, when we are inside the trade, how much does the market move against us? And there is Multi-trade Drawdown. How many losing trades do we have in a row? What's the maximum?

Why keep track of this information?

First of all . . . because we sometimes err. We make mistakes as to how much our 'total risk' is. When we keep track of both of these types of drawdown. We may have been fooling ourselves with our risk analysis, and when we keep track of all our drawdown, it tells us how accurate our analysis of our risk actually is. Or if we are risking more than 3%.

Secondly, it has to do with something else every trader must engage in. Something I'll mention later . . . performance analysis. In short - how well are we doing overall? Or perhaps our drawdown is so low, that we mathematically figure that we might be able to increase our risk to 3.5% per trade. Or perhaps our drawdown is such that we need to decrease our risk to 2.8% per trade. Keeping track of

INTER-TRADE DRAWDOWN: Let's say we enter a trade. We're going to short Sugar at 10.15. Ok. Let's say we're capitalized enough, to where we can enter an actual futures position, not an option. Ok. So we're short, and in the market at 10.15 October. Great.

Sugar moves to 10. Fantastic. We're up 15, or $168.00. Great.

Then the market moves back to 10.15. No biggie. Then it moves up to 10.20. 10.25. 10.40. 10.50.

That . . . is inter-trade drawdown. We're inside the trade, but it's moving against us. In this case, our drawdown would be 35 points, or $392.00. We better have around $13,500.00 in our account, to handle this sort of drawdown. If so, great. If not, then a) we should have been stopped out earlier due to risk analysis, so that wherever our account is at - we should be stopped out or b) we're trading beyond our means, and are starting failure in the face. We're risking more, to make a little. Not good risk / reward ratio.

But let's say we're still in that trade. We're adequately funded, and we can withstand that sort of drawdown. Then what happens? Ah, Sugar starts to head lower. And lower. And lower. Now we're at 9.75, and quite happy. We're $1,000.00 up. Cool beans. Perhaps (if we are adequately funded) we have even added to our position, and are up more. Great! We have an opportunity to add even further to our position with trade management below 9.75! Great! More profit.

But that doesn't change that we had inter-trade drawdown, and it is vital to understanding our systems performance, that we keep track of that drawdown. It's vital to our future risk analysis, that we keep trade of that inter-trade drawdown.

MULTI-TRADE DRAWDOWN: Let's go back to the above example. Let's say our account is only $10,000.00. We can't stand drawdown (risk) of $392.00. Let's say we're stopped out with a $250.00 loss to our account.

That's a fact of life, and it happens. This is what traders must understand. It is proper to lose from time to time. This doesn't mean you are a bad trader. It means our timing may have been off, or the market just did whatever the market was going to do. That's all. We can possibly short sugar still. A poster on a financial forum once made an interesting statement. He said:

It can be hard at times, but you have to let those winners ride. It has been stated here that you can be profitable with only 30% wins. That is VERY true, but not if you don't let the winners ride much farther than the losers. 30% at a 1:1 risk to reward is NOT a winning system. I've been tempted at times to just close out a winning trade because it was up and I was unsure if it would continue on towards my profit target... but in all honesty, when are you ever completely sure it is going to continue towards profit? If you don't let those winners ride on, and always cut them short, you could very well fall into that scenario of 1:1 at 30%.

human natures is such that we do not like losing

[this is] very true . . . and this makes it more of a reason why a high percentage of people that trade eventually fail. Human emotions can be very distracting and by having such emotions, they cut out their profits too early and start to mess up their odds in the long run..

Keep to your risk analysis. What makes money, is not any individual trade. It's the whole thing together. Maybe you enter a short on Sugar #11 in a couple of days, when another timing tool tells you to enter it again. Then you're short from, say, 10.25, and the market heads down to 9.75. Great! Little drawdown, and you've got your profits. You can't let your ego get bruised to where you just ignore good signals, when the market is telling you to enter it once again. Too many traders become disgusted with themselves, and would walk away from Sugar altogether, only to see that in a few days, the market headed in the direction they thought it would. Instead of entering the market as they should again - they blame what? The stop / loss. I've seen many, many traders do this. And then what happens? They stop trading with a stop loss. They get margins calls, and before they know it, they're out of the markets. Then I've heard them rail on how there is a "them conspiracy" and the market is "out to get" the small trader. Anything. Anything but realizing the truth. Their ego was what got them in trouble, not the stop / loss order.

I say the above, and wanted to take an emotional tack, when discussing mult-trade drawdown. You're going to have periods with losing trades. One after another. If your money management strategy is set correctly, if you have an adequately funded account, and engage in all of the above concepts? When this happens - it will be easier to handle. But if not? It can destroy a perfectly good system, and cause you to become an emotional basketcase when trading the markets.

Keeping track of mult-trade drawdown, can also expose weaknesses and strengths in the trading system overall. For example, lets say you're trading markets, and everything is going well. Little drawdown. Remember this - market conditions change. They change all the time. Not just what the markets are doing overall, but they go from nice trending markets, to extremely volatile ones. Some systems work great in trending markets, but horrible in volatile ones, and vice versa. Your periods of multi-trade drawdown, will give you indications as to what sort of markets you should be trading.

You must keep track of those losses. For the same reasons that you must keep track of inter-trade drawdown. It helps you plan out your future risk analysis better, and is needed later, when analyzing your overall system performance.

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