Monday, April 22, 2024

Trading Drawdown Psychology: Overcome the Challenges of Trading Through Losses

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Trading drawdown psychology

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In the early days of my trading journey, I used to get very discouraged during a drawdown.

As soon as I hit a drawdown, I would assume that the strategy had stopped working and would jump to a new trading strategy.

That’s the last thing we should do as traders.

I’ve learned a lot since then and I want to help you avoid this mistake by giving you the tools and techniques to properly overcome the natural doubts that come with a drawdown.

The optimal trading drawdown psychology is to examine the drawdown as objectively as possible. First assess if the drawdown is within the normal parameters of your trading strategy. If it’s not, then review your data to find out why, and figure out a way to fix it. 

Obviously there’s more detail to this process and that’s what I’ll be covering in this article. 

Drawdown is an inevitable part of trading and can be difficult to manage.

However, the way you react to drawdown will have a significant impact on your success.

So if you want to become a more resilient trader and worry less about your drawdowns, here’s what you need to know.

Understanding Drawdowns in Trading

First, it’s important to understand how a drawdown is defined because that lessen can the psychological impact of your losses.

When you understand what a drawdown really is, you can more objectively understand if you should be concerned about a series of losses or not.

Defining Drawdown and Its Importance

Drawdown is a term used to describe the decline in a trader’s account from its peak value to its lowest point before recovering to a new peak value.

This is an essential concept in trading because it can help traders understand the risks involved in their trading strategies.

Drawdowns are typically measured as a percentage of the peak equity value in the account.

For example, if a trader’s account has a peak value of $10,000 and then declines to $8,000, the drawdown is 20%.

It’s important to note that drawdowns are not the same as losses.

You could have a few losses on the way to your account balance reaching new highs.

So a few losses is normal if you have a properly tested trading strategy.

Measuring Drawdown: Maximum Drawdown and Duration

Maximum drawdown is the largest decline in the account value from its peak to its lowest point before a new high.

This is a crucial metric that traders use to evaluate the risk of their trading strategies.

The maximum drawdown can be calculated as a percentage of the peak equity value or as a dollar amount.

But using a percentage is usually much more useful.

It’s easy to calculate maximum drawdown.

Simply look at your performance graph in percentage gained/lost and look for the biggest drop from high to low.

If you want to get more precise, you can simply export your trading log into Excel and use this formula.

There is also software that can show you stats on your live trading and backtesting.

Here’s an example from NakedMarkets.

NakedMarkets drawdown graph

Drawdowns can also be measured by their duration, which is the length of time between the peak and the trough.

The duration of a drawdown can vary significantly, depending on your strategy and the market conditions.

Short-term traders may experience more frequent and shorter drawdowns, while long-term traders may experience more extended drawdowns.

So it’s important to understand both the magnitude and duration of your normal drawdowns, for reasons I’ll get into in a bit.

The Role of Leverage, Volatility and Risk Per Trade in Drawdowns

Leverage and volatility are two factors that can significantly impact the drawdowns in a trader’s account.

The amount of leverage you use will amplify the gains and losses in your account, which can lead to more significant drawdowns.

Many times, just lowering your leverage or risk per trade can make a drawdown tolerable.

A common misconception about trading strategies is that if you increase the risk per trade on a profitable strategy, that simply amplifies the amount of money the strategy will make.

Not true.

Often lowering the leverage or risk per trade will lead to better results because you won’t be as stressed about the outcome and are less likely to make irrational mistakes.

Volatility can also impact drawdowns by increasing the frequency and severity of market movements.

High volatility markets can lead to more significant drawdowns, especially if the trader’s strategy is not suited to the market conditions.

So it’s important to understand if your strategy benefits from volatility or is harmed by it.

Psychological Impact of Drawdowns

Trader in drawdown

Drawdowns are an inevitable part of trading, and they can have a significant psychological impact on you.

In this section, you’ll explore the emotional responses to losses, cognitive biases during drawdown periods, and the effect of stress in decision-making.

Emotional Responses to Losses

Experiencing drawdowns can trigger a wide range of emotions, including fear, greed, frustration, and disappointment.

It could trigger that time you lost in the high school wrestling championship or when you got fired from a job.

Guilt and fear of further losses can cause traders to become overly cautious, leading them to miss out on potential opportunities.

On the other hand, greed can drive you to take unnecessary risks in an attempt to recoup your losses quickly.

It’s essential to acknowledge and manage these emotions to prevent them from clouding your judgment and leading to poor decision-making.

Cognitive Biases During Drawdown Periods

During drawdown periods, traders may also experience cognitive biases that can affect their decision-making.

For example, confirmation bias can cause traders to seek out information that confirms their existing beliefs and ignore information that contradicts them.

Similarly, loss aversion bias can cause traders to become overly focused on avoiding losses rather than seeking out gains.

These biases can lead to missed opportunities and poor trading decisions.

Stress and Decision-Making in Trading

Trading can be a stressful activity, and drawdown periods can exacerbate this stress.

Stress can impair decision-making and lead to impulsive and irrational decisions.

It is essential to manage stress levels by taking breaks, practicing relaxation techniques, and maintaining a healthy work-life balance.

Also examine what kind of content you’re consuming on a daily basis and who you’re coming into contact with.

Negative news programs and stressful music can compound your stress.

Same goes for negative people. 

Figure out how to minimize the impact of these things on your life and you can lower your stress dramatically. 

Risk Management and Mitigation

Risk of ruin

Developing an effective trading plan is the cornerstone of successful trading.

A trading plan includes a set of rules and guidelines that dictate how a trader approaches the market.

Your plan should be based on your risk tolerance, objectives, and trading style.

Remember to always backtest your trading plan before ever risking real money.

Then stick to the plan.

Importance of Position Sizing and Stop-Loss Orders

Position sizing is the process of determining the appropriate number of shares, lots or contracts to trade based on a trader’s account size, strategy and risk tolerance.

Stop-loss orders are an essential tool for risk management.

They allow you to limit your losses by automatically closing out a trade if it reaches a predetermined price level.

Not all strategies need a stop loss of course, but most traders will benefit from using them.

If you have a small account, you should also consider using nano lots. They are a great way to manage risk.

Understand the Parameters of Your Trading Strategy

One thing that doesn’t get talked about enough online is the idea of backtesting your strategy so you understand the maximum historical drawdown of your strategy.

This is extremely important because if your current drawdown is within the normal historical drawdown for the strategy, then you probably have nothing to be worried about.

Of course, you should always make sure that you’re executing your trading plan correctly.

But if you are executing as planned, then a normal drawdown is nothing to freak out about.

Knowing your maximum historical drawdown can take a lot of pressure off you and be more in flow. 

Optimize Your Risk Metrics and Money Management

Another area of risk management and trading psychology that doesn’t get enough attention is the concept of tailoring your maximum drawdown to your personality.

For example, let’s say that “SuperTraderX” tells you that you should risk 2% per trade with his strategy.

He’s a successful trader, so you follow along.

But the drawdowns at that risk per trade can be upwards of 60%.

Most traders cannot handle that level of drawdown, so they quit the strategy, even though the strategy is obviously profitable over time.

What a lot of aspiring traders don’t realize is that a strategy could work really well for them, if they simply lowered their risk per trade.

Sure, they won’t make as much money as SuperTraderX, but they could handle the drawdowns much better.

Maybe they lower their risk per trade to 0.5% per trade and their maximum drawdown drops to 27%.

That’s a lot more tolerable for most people.

From there, you would just need a bigger account to make the money that you want to make.

You can figure out your maximum historical drawdown by backtesting your trading strategy with as much historical data as possible.

Then plug your trades into a Monte Carlo Simulator to get the maximum drawdown over many simulations.

If you can live with that maximum drawdown, then great, the strategy is good to go.

However, if that maximum drawdown is beyond your comfort level, you can plug the results of your backtesting into this risk calculator to give you the amount you should risk per trade to avoid losing more than you’re comfortable with in a drawdown.

Drawdown calculator

So if you only want to have a maximum 27% drawdown, then you would plug that into the calculator, along with some other stats from your backtesting, and it will spit out how much you should risk per trade to achieve your goal.

Strategies for Recovery and Growth

Now that you understand the key concepts related to drawdowns and how they can affect you, let’s take a look a some solutions, if you find yourself in a drawdown.

If you follow this logical process, you’ll start to see how to minimize the impact of drawdowns on your trading psychology.

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The Drawdown Might be Normal

The first thing to consider is if your current drawdown is normal.

If it’s within the parameters of your backtesting and Monte Carlo Simulation results, then you probably have nothing to worry about.

Just be sure to double check that you’ve been following your trading plan.

But if you’re trading your plan and your current drawdown is less than your historical maximum drawdown, then there’s no need to freak out.

It’s all good, relax and carry on trading your plan.

Has Your Trading Strategy Stopped Working?

Now if your current drawdown is larger than your maximum historical drawdown, then it’s time to do some analysis.

The question you have to ask is:

Has my strategy stopped working, or is this just an unusual situation?

For example, there might be some once-in-a-lifetime type news event that came out that moved the markets unexpectedly.

If that’s the case, then your strategy is probably still sound, but you should look into how to mitigate these situations in the future.

On the other hand, if it looks like your strategy may have stopped working, then there are 2 things that you can do to figure out if it has really stopped working:

  • Take less risk per trade
  • Only trade in a demo account

You should continue trading the strategy in come capacity because you want to see if your results go back to normal.

But if your drawdown continues to get bigger, then that might be a sign that your strategy has stopped working and you might have to update it or ditch it altogether.

Psychological Readiness and Emotional Control

Maintaining psychological readiness and emotional control is essential for recovering from drawdowns.

Traders who are emotionally affected by losses may make impulsive decisions that can lead to further losses.

It is important to have a positive mindset and a clear understanding of the risks involved in trading.

One effective strategy for maintaining emotional control is to be sure that you’re in an optimal mental condition to trade and take frequent breaks during the day to relax.

Even if you aren’t trading, taking a break is a simple way to stay focused and have more fun.

Trading doesn’t have to be so serious all the time.

Final Thoughts on Optimal Trading Drawdown Psychology

As traders, we get paid to deal with uncertainty.

If you prefer certainty, go get a 9 to 5 job.

But if you really want to make it as a trader, drawdowns come with the territory.

On a positive note, drawdowns can be valuable learning experiences.

By analyzing the causes of a drawdown, you can identify areas for improvement and develop more effective strategies for the future.

To learn from drawdowns, be sure to identify the root cause of the losses.

This may involve analyzing trading data, reviewing trading decisions, or seeking feedback from other traders.

Once the root cause has been identified, you can develop strategies to address the issue and improve their performance.

If there is even an issue at all. 

Understand your trading strategy, keep good records and maintain a positive mindset and you’ll give yourself the best chance of getting out of a drawdown quickly.

 





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