Your strategy will inevitably go through a Drawdown!

May 19, 2022

Your strategy will inevitably go through a Drawdown. And there's nothing you can do about it to stop that. However, you can learn how to survive it!
Today I will give you actionable steps, that you can use for the next time the market hit your strategy and you feel that everything is going wrong.

Let's start with an idea of what a drawdown is, and why drawdowns happen.
There are an infinite amount of trading strategies and tools that people use to trade and take advantage of specific market conditions.
Some traders are better in trending markets, they trade breakouts. Other traders feel more comfortable in ranging markets, where they trade quick reversals on key levels.

The Math is simple here. Trending strategies will have a poor performance on ranging markets, while reversal strategies will have a poor performance on trending markets.
Detecting the beginning and end of trending cycles or ranging cycles, is blurry. So, if you agree with that, as I do, you can expect your strategy to start failing at some point. And that's the beginning of the drawdown. (This is true for the best traders in the world, as for the worst traders in the world. Nobody scape drawdowns, the quickest you accept this, the faster you can learn how to handle them properly)

So let's start by saying that drawdowns are situations where your strategy experiences a lasting decline in performance, even if you are doing everything perfectly. Drawdowns, happen because strategies are made to take advantage of specific anomalies that can be found in one part of the market cycle, and when that market cycle finishes, or changes, your strategies become less accurate.

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It's important that you become aware of the Psychological consequences of Draw Downs, so you can have a countermeasure for this. Let's take a look at the most common ones:
1) Decrease in confidence (constant negative thoughts about your system)
2) Fear of entering the next trade.
3) Thinking about changing things in your strategy (deviations from the original plan)
4) Thinking about modifying the risk you are using to cover losses quicker.
5) Ceasing your trading execution, and looking for a new strategy.

ALL THESE ITEMS, are the main situations you may start feeling when going through a drawdown. IF you are going through that, it's important that you understand that you are under a delicate emotional state, where your confidence is low, and you are prone to make more emotional decisions that 99% of the time, tend to increase the drawdown.

So the way we handle drawdowns is by having logical and systematic processes in place instead of emotional ones.

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Here you have actionable steps to handle drawdowns:

STEP 1: You handle drawdowns by getting ready before they happen, not when they are happening.
This is true for almost all disciplines, not only for trading. Airplanes have clear plans in case things start going wrong, instead of figuring out the problem at the moment, pilots go to the manual book, and use the template for this situation, plus the fact that they trained those situations several times in simulations.
So, if you want to understand what a drawdown situation looks like in your strategy, you MUST go into the past, and when I say this, I'm not saying making a 3 week backtest. You need to go as far as you can in the past, to find that exact moment where your strategy is not working as expected.

How many consecutive stop losses do I have? 3? 5? 15? 20?

How long does this period last until everything goes on track again? 1 month? 3 months? or a year?

These are the kind of answers you are trying to solve. When doing a backtest you are trying to understand two things. The first one is if your strategy has an edge. The second one is how hard you get hit when things go wrong!

STEP 2: Work your risk management around the stats of your system. Imagine we reach the following conclusion "I have a system, that executes 10 setups per month" and the worst-case scenario I have found is 20 consecutive stop losses during 2 months. What I would personally assume is that 20 consecutive stop losses can be 30. So how much capital percentage should I risk on this system so I don't get knocked out if this TERRIBLE scenario happens.

The answer for me would be 1% per setup. Under the assumption of this unique scenario, I would be 30% down, which is something acceptable, compared to the drawdown of conventional investment vehicles like S&P500 where we observed those kinds of declines, in the last years. The main point here is that you need to adapt the risk you are using on the strategy, to the stats of it, and your risk tolerance.

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Let's recap the key aspects of this post.

1) Drawdowns are inevitable, your strategy will be hit by this scenario eventually.
2) Drawdowns cause an emotional disturbance and are the main reason why people make really bad decisions.
3) We handle drawdowns by getting ready in advance. Through backtest, we can understand the edge of our strategy and the worst-case scenarios.
4) We adapt the risk of our strategy, by considering a terrible scenario, like 30 consecutive losses.

This will not eliminate the feeling during this period, but it will bring you a work frame to make logical decisions based on data, instead of emotions. Implementing this type of thinking will make your strategy more robust, it will help you go through these situations, and most importantly it will protect you from making stupid things with a strategy that has an edge, and actually works!

Thanks for reading!