Saturday, March 29, 2008

How Big of a Drawdown Can YOU Take?

What you've been watching in the performance of this account is the way real trader's accounts perform in extraordinary market conditions. Fortunately, OneNightStand and FirstStrike are the types of systems which benefit from volatile moves. When they don't get stopped out first, they offer one of the best overall risk/reward ratios possible in trading.

But they are frustrating for the average beginner, because many have been (incorrectly) conditioned by ridiculous advertising to believe that it is possible, no-- that it is a fact that there is some low risk method which should make money consistently every week like a paycheck.

This week, I just read about a new forex trading system on the net where supposedly the guy promoting it borrowed money on his credit card to start an account and then used some "trading robot" to effortlessly build up a large account in just weeks. I have severe doubts about that.  If that was possible, you couldn't find anyone working at McDonald's tomorrow.  Their workers would all be trading from home instead.   

In my experience, real trading gets profits in chunks.

The market loves those with the “paycheck” mentality and there is always a Black Swan designed to clear them out. Because the norm of the market is to provide Black Swans for everyone. (See Black Swan by Nassim Taleb)

Idea: Trade a method which profits from Black Swans.

It always comes back to utility theory and individual tolerance for drawdowns. Nobody sane is ever thrilled to be in a drawdown. If a person states that they can handle a 50% drawdown, they “typcially” are actually able to handle only 20 – 30% drawdowns at most, and probably less. Especially so if they have never been in a major drawdown before, and are just intellectualizing their personal strengths.

Deep drawdowns are like being on the rack, the medieval torture device. Actually it's worse, and I'll tell you why.

It is the mind which is being tortured the most, just like the original device. In the physical device, the fear of not being able to recover was the greatest power it had.

In trading through a drawdown, one knows that if you lose too much capital, you may never be able to raise more or even be able to efficiently trade with smaller capital to get back your losses. The whole psychology of “loss” is a book on its own. In the trading context, it causes the trader to doubt himself, the system he is trading, the markets, an even other people due to their natural reactions to the loss process which the hapless trader is currently experiencing. (Think of spouses and other family pressure to give it up, or even the fear of looking stupid while others are profiting in some other sector!)

Why is trading through a deep drawdown worse than the physical torture?

Because you are doing it to yourself!

You risk inflicting more pain by taking ever more successive trades, while perhaps losing belief that you really are doing the right thing! Or give in to the market and situation; quit trading, accept the financial damage already done, and take complete responsibility for being a loser at yet, another challenge.

I'm really uplifting here aren't I?

I have experienced many deep drawdowns before recovering to new equity highs. The fear of drawdowns is much greater than the reality, if you can be certain that your method will bring you out of the drawdown, regardless of how scary it may be.

Because of the potential reality of numerous consecutive losses driving a stake into your account's heart, position size in and out of the drawdown is another personal decision which can bring the “rack” reference back into your frontal lobe.

Why am I mentioning this as the Challenge account has ballooned? Because a similar dilemma exists for the trader when you have a large increases. If you start backing off on your position size because you are now experiencing success, your future wealth will be substantially less than it should be if you continue trading your system with a given edge.

The same questions arise in the mind as in the drawdown scenario, just in a different context. It is very possible for you to start doubt your system, the one which made you all the money you are now afraid of losing.

This is why every responsible trading book or manual strongly suggests that one only trade with money that you can afford to lose.

What 's rarely covered is what happens when you actually make serious money from your trading activities and it begins to exceed what your “normal” occupation provides you.

Further discussion on this subject will be had as we go into a serious drawdown.


Have a great weekend.

Joel Rensink

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