How to Recover from Drawdowns: By Justin Paolini

Drawdowns happen. It’s a fact. However, most traders are not capable of dealing with drawdowns. They try to avoid them, which leads to premature profit taking, moving the stop loss to breakeven, and eventually a nervous approach to the markets as the sole focus of the trader is to “not lose”.

This mindset breaks down in the face of adversity, when the inevitable happens: a string of losses. This is where the rubber meets the road, the moment where good traders emerge and mediocre traders throw in the towel.

In our London Open Signals, which have been running since 2015 and are thus almost 4 years old, we have gone through a long drawdown which required serious effort to claw back from. The greatest lessons come from the ugliest occurances and so here are the keys to our recovery. Hopefully they will help you manage your risk better and trade your way out of drawdowns with confidence.

Down in the Doldrums

The dictionary defines the “doldrums” as a belt of calm and light winds north of the equator in which sailing ships were often becalmed. In other words, it means “dull & depressing”  circumstances. Well that is exactly what we went through from October 2016 to August 2017: 10 months of doldrums!

Now know this: most traders cannot trade out of a drawdown because the string of losses plays with the mind. Without confidence in your approach (which comes of course from competence as demonstrated by consistent results over time), losses induce traders into bad habits like:

  • overanalyzing “what went wrong”;
  • adding indicators in search of better confirmation;
  • dropping down to smaller timeframes in order to trade more frequently and “get out of the drawdown quicker”;
  • bringing another trading strategy into play in order to raise the trade frequency;

and my personal favorite

  • martingale position sizing (trading larger positions when losing).

So here are the usual effects of these habits:

  • overanalyzing leads to overfitting some kind of technical (chart-based) explanation for the negative occurrance. Very rarely do traders wonder about things like event risk (trading ahead of key data), broader conditions (trading in a dull market, trading when the market is waiting for some political development, trading when prices are extended on the day/Week, etc.) or just pure bad luck. There’s so much that we cannot know and as traders and we must accept that fact. Moreover, the only real “mistake” in trading is not following the plan.
  • adding indicators just keeps traders going back to the drawing board after each loss and keeps them in a continuous loop.
  • dropping down to smaller timeframes usually means traders start “looking for trades” as opposed to waiting for them, hence throwing caution and quality to the wind. In turn, this means they push their risk limits (due to the enhanced trade frequency) and just raise the possibility of deepening the drwadown.
  • adding another strategy is pure madness. If you have studied a strategy and got into a drawdown with that strategy, then it may be that market conditions are just unfavourable. It may mean you should be trading less – not more. If you are specialized in trend trading, and all of a sudden want to be a range trader, good luck. Always consider that it takes a specialist to make money in the markets. So unless you are also a specialist of various strategies and situations, avoid attempting to be a jack of all trades. Stick to your guns and keep things simple.
  • martingale strategies are simply suicidal because instead of diminishing your risk, you’re actually adding a ton more risk and your account will sooner or later be at risk of a margin call.

How We Survived Our Drawdown

After looking at the bad habits, let’s look at the good habits that helped us contain the damage and eventually trade our way out of the drawdown.

  • The first thing we did was recognize that the loss into October 2016 was outsized. It was abnormal compared to our previous history. Market dynamics had changed in a way that our model was not adapting to. Knowing what is “regular performance” and what is “irregular” is something every trader should know.
  • The second step was to recognize what had changed. It was pretty obvious to us that volatility conditions, alongside our typical trade duration, were the culprit. It’s easier to profit intraday when volatility is higher. When volatility drops, usually it’s better to lengthen the trade duration. Instead of going for intraday profits, going for multi-day profits usually works better.

  • The third thing we did was cut our position size in half. We knew the trading model itself wasn’t broken. Just that the trade management parameters needed reconfiguring. This would take some time. In the meantime, we had a mandate to issue signals on a daily basis to clients, so we “had to trade”. At least we were risking less in the event of continued losses.
  • The fourth thing we did was commission a study to a client of ours with a peculiar predisposition for detailed analysis. This took time and in the meantime we cut our position size again. So effectively we were trading 1/4 size.

As a side-note, trading smaller size gives you a lot of flexibility. Remember that the key to longevity in trading (as in gambling) is to not lose all your chips. That’s why we often suggest that people establish a clear risk limit for the month and cut their position size before reaching the risk limit. You give yourself more opportunity to make the loses back. By continuing to trade at full size, in the midst of a drawdown, the psychological and financial pressure can become unsustainable.

  • When the results from the study came in, they confirmed our suspicions. We needed to do three things: change our management style and allow positions to be rolled over if they were working well; tighten our stop loss and allow for multiple-R wins; be more selective with our trades.  These decisions were somewhat unpopular, but necessary. We had to change our mandate towards clients. Instead of issuing one signal per day – our “best guess” basically – we were only going to issue trades when our edge was fully present. By tightening the stop loss, we would experience larger gains but also suffer more frequent losses. There is a trade-off between equity curve steepness and win rate.

These decisions were difficult to implement because we would be drastically reducing the quantity of signals. Since our business is devoted to trading signals, we decided that we needed further diversification and went on to structure two alternative signal services, the End of Day and the Newsflow signals which are now included in the Signals Portfolio. And we maintained the Active Trader Signals for those traders that do seek more activity each day.

We finally implemented the changes in August 2017 and that was the start of our recovery. We continued to maintain the 1/4 position size until January 2018. With some positive momentum behind us, we increased the position size to 1/2 normal size until May 2018 and now we actually modulate the position size depending on market conditions. For example, in October due to the equity market rout and uncertainty surrounding Brexit and the US Mid-Term elections, we traded 1/2 size.

Key Lessons

The main things that helped us survive our drawdown are the following:

  • acknowledging that something is wrong;
  • cutting the position size accordingly;
  • reducing trade frequency;
  • adopting a quality filter based on the market type – for example only trading in strong bull or strong bear market types.

The overarching principle is to not lose all your chips. In practice, it means don’t exceed your risk limit for the month. A good starting point for this is to determine a drawdown level you’re comfortable with for the month. Let’s say 3%.

Then, you need to know on average how many trades you take during a month. With an adequate quality filter, perhaps estimating 3 trades per week can be a reasonable long-term average. That would be 12 per month.

Based on a normal distribution, what are the odds of having X consecutive losses based on a 50% win rate and your trade frequency?  Use a table like this:

With a 50% win rate, you could end up with 4-5 losses in a row at any time during the month and still be within normal parameters.  So being conservative, we want 5 losses to “fit” into our risk limit for the month (3%). But we also want to have chips left on the table in order to take any other opportunities that arise during the month and help us recover. So a logical way to do this might be 2%/5 = 0.4% per trade as a base risk, and then cut the positon size in half if you lose 2% during the month. At least you have 1% of risk capital left to deploy.

However you decide to do this, NEVER exceed your risk limits for the month. There will always be another trade, a better trade, a clearer trade. But the question is: will you be around to take it? Or will your account already be in a margin call?

Over to You

We’re not market wizards. We’re ordinary traders with some industry experience behind us and a tad of common sense. This should prove that it doesn’t take a genius to trade consistently, or trade out of drawdowns. It just takes hard work, the right knowledge, and some maturity.

If nothing else, our experience should demonstrate that taking care of your downside/managing risk appropriately really is the key to longevity in this business.

Good luck!

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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