Saturday, July 14, 2012

Severe drawdowns and blow ups

A drawdown is the drop in your equity from a prior high to the current low. This can occur following one huge loss or a fun of (relatively) smaller losses. Remember that, if you lose 50% of your trading equity, from that level you need to achieve a 100% gain to get back to your prior equity level. A blow up is where a trader manages to lose all his trading equity and 'blows up' his account.

Some very simple thoughts to avoid these devasting events:
  • Use proper risk control - if a relatively minor price move against you causes a severe drawdown or blow up, you have been trading WAY too big a position relative to your equity;
  • Ensure you adhere to stops - the simplest way to avoid a big loss is to take a small losses - as the saying goes "your first loss is the best loss". Stops are placed as per your system rules, and combined with your risk parameters, should ensure that you restrict your losses to 1R (be it 1%, 2% or whatever risk level you choose);
  • Ensure you place your stops where they should be - it can be tempting to place your stops too close to your entry point, in an attempt to try and maximise your gains on a trade. This allows the possibility of a minor reaction knocking you out of your position (and booking the loss) before the trade has chance to move into profit. Stops should be placed where the charts or your system indicates, and not to satisfy some pre-conceived intention to trade a fixed quantity of shares for example. You should also factor in the bid/ask spread  on that particular stock or instrument when placing stops.
  • Use fixed fractional risk management - if you risk x% risk per trade, and this is regaularly recalculated to to reflect profits, losses and capital introductions or withdrawals, in theory it is impossible to blow up your account (ensure you factor in the possibility of slippage or overnight/news gaps through your stop levels, as in those cases you will lose more than intended on an individual trade).
All successful traders focus on what they can LOSE on an individual or series of trades, not on what they can win. Preservation of capital keeps you in the game.

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