Sunday, November 02, 2014

A plan on how to get over a major drawdown or price shock

It is an unfortunate part of trading that people can suffer the traumatic experience of losing a significant part of their equity in one go. In extreme examples, some traders may even blow up their account. This may be as a result of some major unexpected news coming out. It may be as a result of your broker putting most of your money in a downtrending stock. It may be because you took a big position just before earnings were released which then gapped against you.

When something like this happens, your mindset will take a battering, and before you commit any fresh funds to the markets, you need to step away for a while and regroup. As hard as it may seem, how you deal emotionally with what has happened is of paramount importance, and may even determine whether you can make money in the future.

You need to try and eliminate/avoid having feelings of resentment, anger, revenge etc., whether it be towards other traders, the markets, your broker, that guru you saw on CNBC, or anybody or anything else. Those kinds of emotions when being in the markets are fatal! At the end of the day, all trading decisions ultimately came down to you, whether you pressed the button to buy or sell yourself, or entrusted someone else to deal on your behalf.

You cannot change what has happened, no matter how much you would want to, and you cannot let your emotions get in the way of what you want to achieve going forward. If those emotions continue to fester, then they will hold you back.

What you need to do is try and wipe the slate in your mind clean. Yes it may be a hell of a lot of money, but whatever you do, think or say won't bring it back. You need to look at the wider picture - hopefully you will still have your health, your house, family and/or business, and you need to say that, ok, from a trading perspective, this is rock bottom. It's the line in the sand, and we are not going near there again. Things cannot get any worse – the only way forward is upwards.

(This sort of mental approach is adapted from Dale Carnegie's How to Stop Worrying and Start Living).

So, you need to accept what has happened, take responsibility for it, and get yourself ready to move on. Only then can you move on to formulating a plan for what you want to achieve going forward, and how you are going to achieve it.  

Then you need to effect change. While you may consider what has happened may have been down to pure bad luck, the fact is that something in your overall approach made the losses so significant. Albert Einstein’s definition of insanity is to keep doing the same thing and expect a different result. Having seen what has happened resulting in a major drawdown therefore confirms a change is needed in how you approach the markets to avoid that scenario again in the future.

What you will need to do is formulate a plan going forward, ensuring that you focus on both
your mindset and on good risk control, but you need to get the mind right first, otherwise you will simply not stick to your plan. Again, you need to avoid those negative emotions at this stage. You have to accept that you will not be able to make all that lost money back in a short period of time. That only invites further potential disaster. No, going forward you want to strictly eliminate any possibility of a repeat. This will mean being more risk averse, and developing the mindset to ensure that you do not succumb to other emotions such as hope or greed. 

Also ensure to include in your risk management plan what can happen in the event of a 'disaster' scenario. Most traders fail to do this - they assume that, on all trades, they can get out of a trade where their stop is placed. Remember the example of the Curtis Faith and the Turtle Traders the day after the 1987 crash. They made money on the day of the crash, as they were short the market, but due to government intervention, Faith suffered a 65% drawdown overnight - the hard earned profits for the year had gone.

These elements are what most (unsuccessful) traders fail to concentrate on. Yet they should be of far greater importance to you.

You need to have an ‘emotional indifference’ towards every trade, so that, in the long run, you know you will be ahead, but you also need to accept that you can lose a small amount on any given trade. By definition, this will mean risking very little of your equity on each trade. Want small losses? Risk small amounts of money.

Similarly, you can take a lot of knocks in this game, and maintaining a positive mental attitude through the good times and the bad is critical. Even the very best adhere to this - as discussed in this article, Tony Robbins has worked with no less a figure than Paul Tudor-Jones for more than twenty years, and helped him improve his performance!

You can start to work on these things without the pressure of being in the markets. Get your plan ready and clear in your own mind. Then, when you do finally go back in, you will be more confident, and will have an underlying appreciation of good risk control and a better handle on controlling your mindset. You can then develop further your new emotional and risk control when there is real money on the line.

I can almost guarantee that what you would end up doing in the future will seem slow and, without such large sums of money at risk, may seem almost dull. You should look to see much smaller swings in equity (at least on the downside). Any good risk management plan will control the downside, while not limiting the upside. 

The bottom line is that, dealing with risk management and your trading mindset are ultimately more critical than how to determine entries and exits, in order to achieve both long-term success AND to avoid the demoralising drawdowns.

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