Two tricks to reduce drawdowns

Last weekend I took my two older boys to their karate grading.

The six-year-old just had to remember a few key moves, and was beaming ear-to-ear when he was handed his yellow belt.

But my eight-year-old is at the more hands-on level, and took a hefty punch in the face from another kid, before earning his green belt, which he took proudly, still smarting and a little tearful from the blow.

In the car on the way home, I heard him explain patiently to his younger brother, “When you’ve been doing karate as long as me, you’ll get punched in the face too.”

Of course, he’s right – the longer we keep putting ourselves out there, the greater the chance of getting knocked down. We can just surrender ourselves to the risk – or we can look at what we can do to protect ourselves.

What is a drawdown?

We like to look at our equity curves heading always upwards. But even the best, most successful trading strategy has wobbles along the way. There WILL be downs and well as ups. And there’s NO getting away from that fact.

A drawdown is the distance you’ve fallen from an equity peak. So, if your account stood at £12,000 three months ago; and now stands at £10,500 – you’ve had a £1,500 (or a 12.5%) drawdown.

Drawdowns are a fact of life for a trader. We hate them, but because we’re always chasing superior returns – we put ourselves in the line of fire. And the volatility of the market that can give us those incredible returns, will also knock us back at times too.

What many, many traders do is cross their fingers and hope that a serious drawdown won’t hit them until they’ve accrued enough equity to withstand it.

However, the bigger your fund, the bigger the drawdown will be. If you suffer a 20% drawdown of a £1,000 fund, that’s a loss of £200. If you suffer a 20% drawdown of a £20,000 fund, that’s £4,000 that you’re out of pocket.

Plus, we can’t predict where drawdowns will come, although the longer you trade, the higher the risk becomes. In fact, the uncomfortable truth for any trader to remember is that your worst drawdown is still ahead of you (unless you’re about to throw in the towel, that is.)

The lesson is that we should always be prepared for a drawdown. If we always assume it’s waiting just around the corner for us – we can’t stop it from coming, but we can stop it from having such a devastating effect on our accounts.

And these two tricks should help …

Trick 1.

Most of us measure our risk per trade according to the size of our trading funds. Perhaps we’re prepared to risk 2% per trade, so if our trading fund is £5,000, we’ll risk £100 per trade.

During a period of drawdown, a good way to reduce its effects is to start reducing risk. It’s tempting in a losing run to desperately try to “make back” what we’ve lost. But if the market is misbehaving, the most important thing to do is to protect ourselves.

So, if we usually risk 2% on a trade, but our fund size has reduced by 10%, we’d then start to risk less than 2%.

This isn’t a new idea – it was used by the original Turtle traders.

Their instructions were to decrease the notional size of their account by 20% each time there was a 10% drawdown on the actual account size.

So, if you had £10,000 in your account, and you were risking 2%, that’d be £200 risk per trade. But if your fund reduced to £9,000, you’d cut your risk by reducing your notional fund size by 20% – this means that you’d be risking 2% of £8,000 = £160.

If you drewdown further, to £8,000, then you’d reduce your risk again, so you’d risk 2% of £6,000.

And so on.

It’s a form of battening down the hatches when your trading fund is under attack.

The next trick is an even more defensive stance …

Trick 2.

The worst-case scenario for a drawdown is … ruin. Ruin for a trader is when your account has completely gone up in smoke, leaving you with zero in your trading fund.

Pick a maximum drawdown you’re prepared to accept. Let’s say you’ve a fund of £10,000. You’re prepared to accept a maximum drawdown of 50% (£5,000). Never a penny more.

How can you ensure that? I don’t mean just hoping for the best – I mean 100% guarantee that it’ll never be touched?

By only trading with £5,000 of that fund.

The other £5,000 is segregated.

When you calculate your 2% risk per trade, it’ll be 2% of £5,000 rather than 2% of £10,000.

So, if your fund increases to £12,000, you’ll be risking 2% of £7,000.

But if your fund reduces to £8,000, you’ll be risking 2% of £3,000.

This may sound a bit bonkers. Surely, if you only want to risk £5,000 of your £10,000, then that’s all you should have in your trading fund to start with?

But there are two ways this method helps us …

• It forces us to really think about where our points of pain are.
• As our equity increases, we can look at changing the portion of our account that we’re prepared to trade with. You may find that if your fund size increases to £15,000, you actually want to hold on to more than just £5,000 of it in the segregated “safe” part of your account.

The most important thing as a trader is to stay in the game

There’s no doubt that these kinds of tactics can have a negative effect on your overall profitability, but measuring profitability alone doesn’t take into account risk of ruin along the way.

The best way to make serious money from trading is to keep plugging at it long term. Trying to take short cuts is a sure road to ruin – the only way to achieve long-term success is to focus on survival – staying in the game will enable us to reach our financial goals.

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