If you want to win, you have to learn to lose. If you don’t, financial peril awaits. I want to shed light on losses with a focus on how to think about drawdowns in trading systems.
The term “drawdown” is simply trader-speak for a loss or series of losses. If I have a $100k account that ends up falling to $97k this month, then I experienced a $3K or 3% drawdown. If the next month my loss grows from $3K to $6K, then the drawdown has increased to 6%. So on and so forth.
All traders have drawdowns. It’s the magnitude of the hole digging as well as how the trader reacts that determines their destiny.
Rookies dig themselves deep and suffer depression along the way.
Pros shovel shallow and maintain their confidence despite the adversity.
Experience and trust in one’s trading system is arguably the difference between the two. Because the newcomer lacks either or both, they are quick to abandon ship when the going gets tough. If you possess a money-winning system, one that carries a positive expectancy and high probability of success, then the best response to a drawdown is persistence, to continue deploying your trade again and again. Calling it quits when you’re knee-deep in a hole guarantees that you never recover.
The culprit for quitting is easy to spot. It’s the fear that if one continues trading they will continue to lose more money. It’s a justified fear if you lack a time-tested trading system. Which is all the more reason to GET A TIME-TESTED TRADING SYSTEM! Might I suggest Tackle Trading’s beloved Cash Flow Condors system or the freshly released Bear Market Survival Guide? Both teach of systems you can begin using immediately.
But even the best methods will suffer drawdowns. It’s inevitable. The key is to understand what’s typical and how bad the drawdowns will be ahead of time. That way you can prepare yourself psychologically and ensure you position size properly.
Let’s say you’re using something similar to the $10-wide Iron Condor sold each month as taught in the Cash Flow Condors. And, let’s say the average loss, assuming you don’t hedge, comes in around $350. If that’s what is typical, then you need to be psychologically and financially prepared to experience a loss of this magnitude as frequently as the odds suggest.
If you’re not, then you’ll undoubtedly throw in the towel following a lousy month. If the probabilities predict you might experience the occasional year where you suffer this $350 loss three or four times then make sure you’re equipped to handle it.
Of course, worse than the occasional single month loss is a losing streak. There’s nothing like a multi-month losing streak to make you question your sanity and the merit of the system. If you want to make it easier to survive, then you must position size properly. I can trade a small enough number of contracts so that if the worst losing streak ever seen by the Cash Flow Condors system were to strike it would only take 10% of my account. Or, I can be a dum-dum, trade too many contracts, and guarantee peril if a losing streak arrives.
I’m the captain of my ship and in complete control of my exposure. Are you?
Financial freedom is a journey
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