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Article from www.powerdaytrade.com
Drawdowns - They Can Always Get Bigger
May 20, 2001
I will admit, as long as I have been trading, as many drawdowns as I have
gone through, and some totally devastating some of my accounts before the
days I focused on money management, they never, ever get any easier. In
fact, logically, they get harder to go through. Why, because I have been
trading for so long, have done so much research, probably have just as much
knowledge on trading as 99% of anyone out there and still go through them.
More than 15 years of breathing and living the markets and trading, you
would think that someone would have this drawdown thing licked. That
logically makes them even more frustrating. Everyone expects a beginner to
go through drawdowns, but a World Cup champion trader???? But, here I sit,
going through a really hard drawdown again. Fact of life is that for as long
as I trade, there will always be drawdowns. So it is a good thing to
understand everything you can about them in order to properly deal with
them.
First, it is important to know and understand that historical drawdowns are
independent events. One drawdown one year is not linked to another drawdown
during a different year. In other words, one drawdown NEVER sets the
standard for future drawdowns. This is probably one of the biggest mistakes
almost all traders make when evaluating drawdowns. "Well, the largest was
$10k so if it goes above a $10k, then the system is broke". WRONG! WRONG!
WRONG! That is like saying that if the historical drawdown was $10k and the
system is approaching another $10k drawdown, that the system actually knows
that the previous largest drawdown was $10k and therefore better start to
turn around. Or better yet, some traders actually think that the system
KNOWS that it is even in a $10k drawdown. Since each trade is independent
from another, there is NO WAY a system can know what size of drawdown it is
in and
therefore begin to turn around. So if all this is true, then my question is
WHY DO WE EXPECT SYSTEMS TO ABIDE BY SUCH FOOLISHNESS? Well, the short
answer is because many times, we as traders do not want to face reality. We
want to think that there is actually a limit to how big a drawdown can get.
Reality is that if everything I said about trades and drawdowns is true,
there is no limit. If that is the case, the question is how can we use
historical results regarding drawdowns to help prepare us to properly deal
with them?
Here is how I used the historical drawdown results to help me plan for my
World Cup 2001 contest trades. First, I know what the largest drawdown was
on a historical basis. $10k. Next, I also know what the average drawdown was
each and every month; just over $4,500. In fact, if you look at last years
statistics, I think there were only 3 months total that did not have a
$4,500 drawdown at some point during the month. So my average was almost $5k
and my largest only twice that average. Probably not realistic to plan for.
So, I planned for a $15k largest.
There are four main aspects to planning. The first is how much money and how
many contracts am I going to start with. Regardless of how much money, I
always say start with one, if not less. Second, I plan for when I will
increase contracts. Third, I plan for when I will decrease contracts.
Finally, I plan for when I will stop trading the method. All of this is
planned before I ever take the first trade. My plan with PowerTrade in my
contest was to use a variant of my Fixed Ratio method similar to using a
$4,500 delta on the increase. Second, I would not decrease unless the method
went into a $10k drawdown. Third, I would drop contracts twice as fast as I
increased them once the drawdown increased above $10k. Finally, (and this is
the one you need to pay attention to for the purpose of this article) I
would quit trading the method if similar market action during good
performance periods in the past produced a prolonged and sustained drawdown
greater than my max that I was planning for. Right now, I am going through a
drawdown of just above that $15k I had planned for. My plan was to look at
the market and see if the market action during the drawdown was similar to
market action during "good" periods with the system or was market action
similar to that during past drawdowns. The answer is the latter, which is
why I decided to continue to take the trades. In other words, if a system is
properly applied to the market, large drawdowns should occur in similar type
cycles of the market. Likewise, the a system is properly applied, high
performance periods should happen in similar market conditions. This is what
I look for. If my current $15k drawdown was occurring during market
conditions that were similar to market conditions in the past that produced
profits, then my system is suspect.
To give you an example with PowerTrade S&P LT, during average market action,
I suffered, on a regular basis, $5,000 drawdowns. During market action where
trends prevailed, the average drawdown would be smaller. During market
action where sideways movement was dominant, larger drawdowns would ensue.
Hence the size of the drawdown is inextricably related to the type of market
action going on. In the case of PowerTrade, sideways action equals larger
drawdowns. As a result, it is impossible to accurately forecast the maximum
size of the drawdown in terms of dollars unless you have a crystal ball to
tell you how long a market is going to move in a sideways pattern.
If the size of a drawdown can not be accurately predicted, how do you
prepare for them in trading? By dropping to the absolute minimum risk until
the market gets back to normal. If that means trading an emini, so be it.
But the wrong thing to do is to stop trading it when you have the ability to
continue when you know that sideways market action drawdowns are normal for
the method. It is when the market is moving with a discernable trend for a
month or two and PowerTrade S&P LT is going into a drawdown that you know
the method is probably
flawed.
Let me tell you why it is wrong for you to stop trading during these kind of
circumstances. Plain and simple, because there is NOT ONE SINGLE METHOD, NOT
ONE SINGLE SYSTEM that is not governed by the principles I just
outlined with regard to drawdowns. So you stop trading this method, where
are you going to go to escape these principles regarding drawdowns? NOWHERE!
You will run into the same thing, over and over and over and then you die.
The only thing you can do is pick out the method you feel gives you the best
reward potential over the long haul for the risk, and then make and
implement your plan. This is why I chose PowerTrade for my contest, it
offers the greatest potential for the risk involved. Still does and until
the method shows that it is flawed by not doing well when the market is
moving, I will stick with it.
I will let you in on a couple of other things before I end this article to
let you know how I know when a method is not flawed. (when I say flawed I
mean probably unexpected to produce a positive expectation over the long
run. A method is not flawed simply because it goes through drawdowns, or
doesn't catch all the moves or doesn't make money month end without missing,
as many traders define "flawed" as). If I am trading daily bars and the
daily bars are in a pretty good sideways action and producing a drawdown
with PowerTrade, I will look at a shorter time frame in the same market.
Normally, there are some trends that occur within the average volatility of
a market. If the shorter time frames are showing some intra-day trending
movements, PowerTrade should, in theory, be posting some winning trades.
With many markets, intra-day trading is not realistic due to slippage, costs
and lack of profit potential with the intra-day moves, but you can still
look at where the method would have entered and exited and make a
determination. With the PowerTrade S&P LT, I began looking at the S&P XT
which trades on 5 minute bars, far shorter than the LT. While the LT was in
a larger drawdown, the XT was doing quite well. That isn't always the case
as there are times when you have to go to an even shorter time frame to
compare or pull some intra-day trends, but you get the point.
Finally, I want to touch on what I seem to ALWAYS come back to regardless of
what subject I am talking about in trading. Money management. You will
notice that I listed four main aspects to planning for drawdowns. Three of
them had to do with proper money management. There is an entire article
dedicated to this one principle to dealing with drawdowns. When a method is
producing profits, take advantage of it with proper money management and
plan to that point of no return. The point of no return is, in theory, a
point that your account reaches that, regardless of what happens from then
on, you can not end the account in negative territory. In other words, you
apply proper money management so that you can continue trading the method
even if it goes through drawdowns unimaginable. For example, I started with
$15,000 in the World Cup contest this year. During good performance periods,
I took the account up to over $107,000 and reached a point of no return. At
that time, I had increased to trading 6 contracts. A drawdown ensued and I
began dropping contracts according to my PRE-TRADING plan. Eventually, the
drawdown reached a point to where I was once again trading only a single
contract at $55,000. This means that I could continue to suffer an
additional drawdown of $40,000 and still be making money in this account.
In conclusion, drawdowns are not as predictable as most traders believe.
Further, the mere size of a drawdown does not indicate whether a system is
"broke" or not. The next time you plan trading a method, or the next time
you begin to suffer a drawdown larger than you expected, make sure your
expectations were based on the proper data and plan them out with proper
money management.
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