Thursday, May 20, 2010

Looking at Losing Accounts - 5 Tips to Get Through Draw Down Periods

I think that perhaps the hardest challenge successful traders must face is the losing account. All successful mechanical systems I know - and also most manual traders - go through extensive periods of draw down which can go from anywhere to a few months to a few years. Most people underestimate the difficulty of having a losing account and having to look at its balance day in and day out. That red number screams "loser" to you and the mere act of opening up your account to trade becomes - sort of - torture. Through today's post I want to give you - fellow trader - a few tips to survive to those long and deep periods of draw down you may get into. I will give you some pointers that have given me the psychological strength to get through draw down periods and reach success in automated trading.

Picture yourself after one year of starting to trade your live account. You are currently at a draw down of 10% and you have been losing for most of the year, reaching the last equity high sometime almost 8 months ago. Looking at your account - which now reminds you of your 401K in late 2008 - is becoming difficult and you are seriously thinking about calling it quits and changing your strategy for a better one. Should you give up ? Should you continue ? Pay attention to the following tips to find out.

1. Ask if the current situation was predicted. The first thing you need to ask yourself is a very simple question. Do simulations or previous live trading predict this outcome ? If your simulations or your previous live trading predicts that you will be in an extensive and deep draw down period then there is no reason for you to panic since you are within a predictable scenario. This is part of your trading system's way of behaving.

2. Do not rely on faith. I simply cannot stress this enough but successful trading is not about having a successful strategy and trading it without any observation hoping that you will eventually go out of a draw down period. Some strategies do fail and relying on faith will only make you empty your account. Your best ally when it comes to dealing with draw down periods is NOT faith its actually knowledge. When you know your trading system and you have confidence, things will be MUCH easier to do.

3. Have a worst case scenario. All good strategies which have worked in the past may reach a level of draw down where you are not willing to trade them anymore. This is the reason why you always need to trade strategies taking into account that future conditions will bring you a draw down of about double the historically predicted. No only does this allow you to be much more conservative but it allows you to have a "worst-case scenario" you'll be able to handle. Also, don't be flexible with this outcome, if the worst case is reached, you quit trading that system and that's it. The system is too risky to be worth trading now.

4. Understand what you are trading. Maybe the paramount reason why people fail to follow long term profitable strategies is due to the fact that they don't have the necessary knowledge and confidence to go through draw down periods. Having predicted risk and profit targets before getting into any system is absolutely vital for you to succeed. Some people trade a given strategy for months without even knowing its risk and profit potential, a very dangerous thing to do when dealing with draw down periods is of inmense importance.

5. Look and Analyze. I know that it may be depressing to look into a two year account which has had nothing but draw downs - something bound to happen with strategies such as the Turtle Trading System - but in the end this is something you need to learn to live with. Open your account, analyze what is wrong and understand why you have been losing. Analyze the predictability of this outcome and match it with your worst case scenario and understanding of the strategy. Ignoring your account and pretending the draw down does not exist is NOT a good thing to do. It is a practice - human but childish practice - which in the end will only lead you to a lack of understanding and willingness to pull the plug when you simply shouldn't.

So as you see, it is actually not very hard to know what to do to weather those draw down periods. In the end, what you need is simply to have a plan, understand it and follow it. You need to have clear profit and risk targets, a worst case scenario which account for worse than historical performance (of course, the future may be worse) and a clear mindset in which you understand that draw downs are real and you WILL have to go through them.

If you would like to learn more about automated trading systems and how you too can be successful in automated trading using sound strategies with realistic profit and risk targets please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

3 comments:

C. Smith said...

Daniel-

That's a great post and oh so true.

Last night I came very close to loosing 5 months worth of gains in my live account on a single trade and it was very tough from a psychological perspective. I'll let you know how it worked out on the weekend.

Anyway, as humans we are not well programmed to persist in doing things which are failing for a long periods of time. That's why trend following is so difficult.

The great trend followers, John W Henry, Richard Donchian and Turtle founder Richard Dennis knew this but they had the education and self-control to get through periods of drawdown this and eventually make the big money.

BTW - I read a great book on the topic called "Trend Following" by Michael W Covell. It should be required reading whenever your system goes into drawdown to remind you why you are a system trader. That and 'Reminicences of a Stock Operator' by Edwin LeFevre which is another classic.

In the end, the only defense is to trade enough systems so that they are all unlikely to go into extended drawdown all at the same time. I'm thinking between 5 and 10 systems should be about right.

Anyway i'm starting to ramble.

Great job again on the post. As usual you are spot-on and 2.5 years ahead of me!

Chris

C. Smith said...

Daniel-

Of course its also possible that the system is a loser and should be dumped.

Its quite possible that we well-researched long term profitable system can become a loser due to changes in the market as well as availability of the system itself.

That's why I think a hard stop loss on any system is required. 50% of the system equity is what i'm thinking.

Chris

Daniel said...

Hello Chris,

Thank you very much for your comments :o) I am glad that you are enjoying my daily posts. You are also right about the books, they are great suggestions for anyone who may want to learn more about psychology and trend following (I have read them both myself).

You are also right about trading several systems, diversification is good at reducing the like hood of a catastrophic draw down but -even then- it may happen that all systems will go into draw down at the same time and the psychological blow will be MUCH bigger. Of course, it is a good idea you just have to consider all the possible scenarios :o)

About the hard stop loss. I would have to strongly disagree. You shouldn't set a hard stop loss on your account may reach potentially lower levels depending on which system you are trading. What you need to do is set a stop loss based ON the system's previous performance and simulations and use THAT. If you are not willing to lose more than 50% then trade in such a way that your system will have a predicted maximum draw down of 25% and your worst-case scenario would then be 50%. The problem is that people may set a hard stop without knowing their system and they will be trading a system that can potentially go into heavier draw down so in the end they will definitely lose that money. It is very important to ALWAYS study the system first and set your "quitting point" at your systems worst-case scenario. You need to set your systems risk based on your risk aversion, you need to have clear projected maximum draw down and risk figures.

I hope this answers your comments and questions :o) Thank you very much again for the comments,

Best Regards,

Daniel

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