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Mental Edge : Drawdowns - A Fact of the Trading Life
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Mental Edge : Drawdowns - A Fact of the Trading Life

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Mental Edge : Drawdowns - A Fact of the Trading Life

Hi all.
i found a bunch of - like i think - very interessting essays on my old harddisk and thought about sharing this here.

its mostly about trading-topics or minimum very related to trading from psychological point of view.
i will not comment things and its also not my personal opinion in all essays for shure -
but for me its very good stuff to have some discussions or some quite thoughts about it.

if you like it, i will make a an ongoing series out of it, once per week or so. let me know.

have fun

Drawdowns: A Fact of the Trading Life

Trader Insight

I once asked a seasoned trader at the CME whether he took a break after a severe drawdown. He said: "Have I done it? No. Have I felt like it? Yes. The other side of my brain has said to me 'I'm not going to run away from this, put me in the lineup, because at one of these at-bats, I'm going to break this slump.' And if I don't go to the game, then I'm never going to get out of it." Drawdowns are psychologically distressing, especially to novice traders without a proven track record. But even seasoned traders may want to take time off before trading in earnest. A seasoned hedge fund manger said, "I have a personal rule that I don't mess with: If I drawdown more than three percent in a month, I go in the penalty box and I can't trade for the rest of the month...It is written in stone. And let me tell you, when I'm getting like two points or so on a drawdown area, I really start picking the trades. The edit process gets way longer because I hate going to the penalty box...If I drawdown more than 20 percent in the year, I'm out for the year: Penalty box." It's easy to feel beaten down and somewhat afraid to get back up and fight after a major setback, but ultimately, only the traders willing to get back up have the potential to break even and get past the drawdown. That said, it is still not easy.

Feature Column

In college I had a secret fantasy: I wanted to "walk on" as a receiver during the last 20 seconds of the Rose Bowl and catch a winning pass. It can't happen. Even if I had the talent to play college football, the coach of my college team probably wouldn't let an inexperienced player play in the Rose Bowl, or any game for that matter. But it's a great fantasy. When it comes to trading, however, many novice traders after a severe drawdown try to do the equivalent of playing in the Rose Bowl. They try to play like a pro, but they don't have the experience. After a drawdown, it is hard to know what to do emotionally. Many novice traders struggle with trying to find the difference between fantasy and reality when trying to recover.

When a novice trader is in a drawdown, he or she needs to believe that it is possible to come out ahead. But is this a realistic expectation? I must admit, some of the novice traders who read my columns keep an optimistic attitude, manage their risk, make trade after trade, but at the end of the year, feed their accounts. For some traders, surviving a year breaking even or with minor losses is actually pretty good. You wouldn't expect to be able to catch the winning pass in the Rose Bowl unless you've prepared for it, so why expect to profit when first starting to trade? You will go through winning streaks and losing streaks. Unfortunately, that's a fact of trading. In the end, you must not let it faze you. It is essential to anticipate drawdowns and survive the learning curve. That said, it is vital to manage risk. A lot can go wrong. A trading system will fail at times. Market conditions will change. Adverse events may ruin your trading plans. The cautious trader survives.

It's easy to say that you should believe in yourself, your system, or your trading method, but what if you don't have an established track record? Even a seasoned trader may not have unwavering confidence in a method. As Mike, a seasoned hedge fund manger, put it, "A trading model is to be used. Never believed. The idea that one model fits all markets, in all times, and in all circumstances is ridiculous. I trade differently today than I did in 1970, 1980, or 1990. I used different models."

It's important to be skeptical. That doesn't mean that you should question your method, but realize that market conditions change and you should be prepared. You may have to change your method to keep with changes in the markets. In addition you should manage risk. As Mike put it, "This is what ninety-percent of trading is about, and I think all good traders will agree with me: It's managing the money...You've got to balance the commitment size of your capital. What percentage do you commit? For instance, in the beginning of the year, I'll risk maybe two and a half, three percent. I may have 80 positions on, but I'll only risk two and a half to three percent. I also like to have a reserve amount, because having traded for 28 years or so, I have war stories. Chernobyl. I was short beans. Got whacked. Asian crisis. I was long S&Ps. So I have a reserve...Instead of trying to always be the infallible human being, count on yourself being fallible. In fact, promise yourself you're going to be a fallible human being. So, if you're counting on yourself being fallible, what kind of profit-to-loss ratio do you need to still make money? I began to require that I must see a risk-to-reward ratio of two and half to one, or three-to-one. So now, if I'm wrong for a dollar, after six times I've lost six bucks. But if I'm right four times, I've made ten. Net, I walk away with four."

For seasoned traders with a winning track record, it's easy to stay optimistic and think in probabilities, but if you are new to this business, it is wise to stay cautious. You cannot crack under the pressure, but you should anticipate drawdowns. Make sure you have enough money saved for a major setback. In addition, trade with money you can afford to lose. Even the best systems or seasoned discretionary traders have drawdowns. Don't get caught off guard. Be prepared by managing risk. If you manage risk, you will be able to survive the learning curve and learn to trade like a seasoned, winning trader.


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