There is an abundance of educational material on succeeding at trading. Most of it covers taking profits and what to do with them. This treatment often gets new traders excited about trading and pulls them into the game.
However, it is rare to find anything about the other side — the downside of trading. Wins, of course, are accompanied with losses. It’s the less glamorous side of trading, but handling losses is at least as important as booking profits.
No matter your trading style, losses will be there and often they come in streaks, testing the patience and resolve of any trader. This is when most novice traders quit. The defining moment for a trader is how he is able to cope through the bad periods. No matter how well you prepare for the downside, drawdown periods will always be trying and there is this constant voice whispering to your ear: “Quit now before you lose more.”
But while you can never escape losses, you can learn to understand them and trade through them to benefit from the winners to come later.
IS IT BROKEN?
You started your trading business, so you must have faith in the original trading plan. You didn’t jump into the markets assuming you would fail.
It is quite natural to want to protect your original risk capital. That tendency leads most beginning traders to err on the side of being too conservative. So, when they suffer early losses, they assume their trading plan or strategy is fundamentally broken (see “Time to bail?”). Perhaps you didn’t test it thoroughly, or maybe the market has entered a new phase that you weren’t able to test? Thoughts like that often encourage new traders to abandon ship right when a turnaround is imminent.
However, just like a typical start-up business, you have to trust your research and not give up because you succumb to the emotions of early disappointment. It may not be comforting at the time, but losses may be part of the calculated strategy or trading plan. Losses happen to everybody.
All this said, it is important to stop once it has become clear that the assumptions the strategy is based on are not holding up anymore. The situation is similar to the business venture, where the service or product you planned on selling doesn’t attract customers. But that decision needs to be based on science, not emotion.
KNOW WHERE YOU ARE
The strategy or trading plan’s performance should be evaluated from time to time. This should be conducted whether things have been going good or bad. The exercise will give you a good understanding of the actual situation even if the recent trading has left you feeling frustrated.
Specifically, during the drawdown it is important to keep your eyes on the equity curve to avoid quitting too early. If the equity curve has been making consistent higher highs and higher lows then you are actually doing OK, even if you are in a drawdown period (see “Re-assess success”).
Another important measurement is the maximum expected drawdown. Discretionary traders may not have such a number, but if you are trading a mechanical strategy, then you should know what this number is.
Compare your current drawdown figure with the maximum expected drawdown. Is it being breached? Keep in mind that the maximum drawdown figure should be evaluated in perspective. Current characteristics of the trading vehicle could be different from the characteristics at the time of the maximum drawdown during the testing period.
You can’t expect the future to perfectly reflect the past. Because of that, some system traders will use 150% of the maximum historical drawdown to allow for more adverse movement in real-world trading.
AVOID OVERTRADING
Going through a drawdown period, trading actual money is emotionally quite different compared to looking at drawdowns on paper.
Indeed, many veteran traders will say that learning to manage your emotions is one of the first exercises new traders should work on. One of the best ways to accomplish this is to trade small in the beginning. Build up your confidence level through time, increasing the trading size gradually.
As you increase your trading size, you also should rely on a prudent money management formula as you increase your exposure. The formula or plan does not have to be complicated, but it should dictate clearly when to add or drop contracts. If the money management plan gives choices in different levels (aggressive, conservative, etc.) then consider using a more conservative one to start with (see “Go small”).
FOLLOW THE PLAN
Do not focus on the profit or loss in day-to-day trading. Anyhow, it is basically a useless exercise because whatever you made or lost in one day, you may lose or gain the next.
Instead, focus on following the rules of the trading plan or strategy. This is actually a lot harder to accomplish than it may appear; you will encounter many situations where rules dictate one action and your intuition tells you to perform another. You have failed to execute the plan if you follow your intuition in such a circumstance.
If you did worse, then you just paid the penalty for not being disciplined.However, assume you did better by following your intuition. With every instance like this, you begin feeling more confidence in your intuition and bending the rules becomes the norm. Soon, you’ll start to wonder why you bothered with the rules at all.
Unfortunately, few of us can trade successfully on intuition alone. Sooner or later, and probably sooner, the markets will punish you for being undisciplined. Furthermore, most traders start trading a system near the peak and drop it during a drawdown period. Next, they go searching for something else. A trader is likely to go through similar cycles until the money to trade is gone. This is tantamount to buying high and selling low. It is needless to reiterate where this leads.
If you really like to fish for the strategy, then it would be more prudent to find a solid system or strategy in a drawdown. The closer to the point of stopping trading — say, a 150% maximum drawdown figure — the better. The risk of trading such a strategy is small, as you would be risking substantially less than the designed maximum drawdown.
Here are the important points:
• Do not quit before it is clear the strategy or trading plan has failed.
• Follow the plan, not your intuition.
• Have realistic expectations about profits and losses. Trading is about probabilities and sometimes the lower probability event happens. Do not let such events derail your trading plan.
• Do not concentrate on losses or wins from single trades.
• Regularly plot and keep your eye on the equity curve.
• Start trading small and increase the size gradually.
• Use a prudent and conservative money management plan.
As long as the individual winners and losers are falling within the normal values of your testing, don’t be tempted to adjust your system just because you hit a streak of losers.The bottom line is that the full picture of success is not written in the short term. You must give your trading plan a chance to succeed.
Robert Steelman is a principal at Theseus Trading. His background is in technology and he is a self-taught trader specializing in mechanical systems and option writing. E-mail him at robert@theseustrading.com.
