Risk Management: How to Handle Drawdowns

Drawdowns are inevitable. Every trader will have from time to time a losing streak, but if handled properly, it should not be a major obstacle for anyone. The most common mistake new traders make is to trade aggressively when facing losing trades. They either add to a losing position in hope that it will turn into their favour and they will eventually make a profit out of it. Or they close their losing positions/get stopped out, but then trade with even bigger position size on their next trade, trying to cover the previous losses. While sometimes you might get lucky using those methods, in the long run, it will end badly.

What you have to do when facing a losing streak is to decrease your risk per trade. For the first example, let’s take a trader who has an account balance of A$10,000. He will have five losing trades in a row, but instead of lowering his risk per trade, he prefers to get aggressive to make the money back quickly.

 

Initial Account Balance ($):

Loss per Trade:

Account Balance ($):

10,000

2%

9800

9800

2%

9604

9604

3%

9315.88

9315.88

3%

9036.4

9036.4

3%

8765.31

 

A series of five losing trades in a row is not unlikely and as you can see in example above that it would have cost the trader A$1234.69 and taken his account down by 12.35%. Even if he had kept his risk per trade fixed at 2% instead of increasing it to 3% after the 2nd trade, it would still be a significant drawdown for only five losing trades in a row.

When facing a potential drawdown, it is good to take action early. Let’s take a look at the second example.

 

Initial Account Balance ($):

Loss per Trade:

Account Balance ($):

10,000

2%

9800

9800

2%

9604

9604

1%

9507.96

9507.96

0.5%

9460,42

9460,42

0.25%

9436.77

 

As you can see, the trader has the following rule:

After two consecutive losing trades, cut risk to 1% per trade.

  • If it is followed by a winning trade, return to 2% risk per trade.
  • If it is followed by another losing trade, cut risk to 0.5% per trade.
    • If it is followed by a winning trade, return to 2% risk per trade.
    • If it is followed by a losing trade, cut risk to 0.25% per trade and keep it at that level until a winning trade occurs.

Cutting risk to 0.25% per trade may seem a bit extreme to some traders, but it can be of great help when facing losing streaks and as visible in the second example, trader B has a loss of only A$563.23 compared to the A$1234.69 that trader A had.

Losing streaks are normal. However, if your percentage of losing trades has suddenly increased and you are facing an unusually large losing streak, you have to investigate the reason that could be behind it. There are two main reasons that cause drawdowns:

  • Your trading strategy is not suitable for the current market environment – for example, if you have a trend following strategy, it will obviously perform worse in an environment where most currency pairs are caught within a range. In this example, you should adjust your risk and be pickier when choosing trades or adopt a new strategy for the current market environment.
  • Personal reasons – it might not be the strategy or the market environment, but rather you that is the main reason behind the drawdown. Perhaps there are some problems in your private life that are negatively affecting your trading decisions or you stressed out or expecting too much. The list of potential problems could be endless, but the most important thing is to realise and accept that you are currently NOT at your best. Then, you can cut the risk per trade until the problems have been eliminated or at least, until they are not having a major impact on your trading performance anymore.

The next time you are thinking about increasing your risk when facing a drawdown – look at the two tables above. You sure will change your mind.

Good luck!

 

 

Contributed by Milan Cutkovic  

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