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Itās 10 pm here in New York, Friday night; currently sitting on the balcony, facing the Empire State building. Itās not too hot, not too cold. It feels perfect. Iām sipping a questionable āRed Stripe Jamaicanā Lager after finishing my weekly review of the trades I took and checking in with myself on how I feel after a tough trading week.
I donāt feel like going to sleep, and the magical atmosphere emanating from this beautiful balcony inspires me for this Sundayās Letter.
Drawdown. š
Most people donāt accept them. Very few people talk about it. And if they do, they remain vague. Why? Most likely because theyāve never overcome one.
The two key takeaways from this article are:
Understand why itās necessary to accept drawdowns;
Build a framework around it to mitigate your risks and react positively when it happens.
This is not an easy topic to discuss, as everyone reacts differently. However, I still want to share with you how I approach them and what I changed over the last few years to create a framework that allows me to be less anxious when I encounter a few red sessions in a short period.
Before we start, I advise you to read āHow I scalpā, āLost big $ today? Ask yourself the good questions...ā and āThe amazing compound effect of your loser mentality on your trading resultsā if you havenāt done so yet. They all go well together.
The first thing Iāve changed is to stop being scared of drawdowns. They are inevitable. You have to live with them. You can see them as a larger version of taking a stop during the day. I like logical things. So hereās one: itās a fact that you canāt win all your trades. Even the best system will have losing trades. Over a long period (hundreds of trades), youāre guaranteed to find yourself in a losing streak longer than usual, which is called a drawdown.
The reaction youāll have to that drawdown will define you as a trader. It will inevitably highlight if you have built strong mental and technical foundations.
Technical, because maybe you were simply in a ālucky streakā, and your system doesnāt have any edges.
Mentally, even if you have a winning system, you must keep executing it flawlessly to get back on the right track regardless of the recent outcomes.
Now, the difficult part is to remain focused. There are two ways to find yourself in a drawdown:
A sudden large loss (severity);
A multitude of small losses (frequency).
Regardless of the way you got there, chances are that you need to take a break. Depending on your capacity to take the hit, it can be one hour or a few days.
I need at least a day off when my drawdown gets over 10%. Iām not running a hedge fund where the rule is to have drawdowns below 3%, nor am I trying to achieve this. Iām in growth mode. I want to increase my capital, and therefore, I take risks. This is what Iām paid for. However, itās good to keep an eye on the longer-term goals, and below are some numbers you should have in mind BEFORE the drawdown happens, aka, before you start trading.
How to read the above bar chart?
If you lose 10% of your account, youāll need a 11.11% profit to get back to breakeven.
If you lose 50% of your account, youāll a 100% profit to get back to breakeven.
As you can see, it becomes exponentially harder to recover from more significant losses.
In a regular regime, how many trades does it takes you to grow your Portfolio by 100%? And Iām not talking about some gamblish trades you took on 0DTE options that doubled your account, but from a proven strategy where you have hundreds and hundreds of trades.
Luckily, I made all Risk Management mistakes one could ever imagine. I blew up more than 40 accounts during my first ten years, ranging from 1 to 15k; almost all started from 1k or less. So, I thought I knew it all. Once again, trading is a beautiful self-development tool. As I now trade a low 6-figures trading account, I can promise you that I donāt want a 50% drawdown. The bad habits I built and nourished for years with my small accounts are tough to eliminate. Itās a constant battle.
In the past, I could lose 50% of my account in ONE trade. And Iāve done this for years. I was always thinking that the next trade could be the ābig oneā skyrocketing me on my trading journey. Boi, was I wrong.
Here are my ways to approach a drawdown:
Mitigate your risks: you want to avoid high drawdowns at all cost, whatever is the size of your Portfolio. To me, it means cutting my losses and calling it a day when I lose 2% of my Portfolio in a day. This is a bit aggressive, and Iām concisous of it, but itās how I believe I can maximize my returns without hurting my mental capital too much. Ideally, Iād like that number to drop to .5% when my Portfolio will reach $500,000.
Increase size only when you are a winning streak. If I have big profit on a given week, and a A+ setup shows up, I donāt mind sizing up and risking up to 50% of my weekly profit. If the same setup shows up but Iām slightly red on the week, I wonāt size up. Why? Because I need confidence. This is how I work. Then, when a sized up trade gets stops, I might get close to a key drawdown threshold, but at least, it was on previous gains.
When the drawdown happens, letās say 10% for me, itās important to close the laptop. Iām not gonna make back that 10% in a trade, or in a day. It will take me a few weeks. And thatās fine. As said earlier, I like to take a short break, and come back with smaller size. Why? I need to get back in phase with the market. Gain the lost confidence. Get that green day in the book, as small as it is.
Take a moment to understand what went wrong. Letās say you trade a $100,000 account and you lose $10,000. On those $10,000 lost, how much was due to:
the strategy itself (unlucky series of trades);
revenge trades;
larger trades on A+ setup;
Based on the above point, I try to answer as honestly as I can how I feel about this result. I never do that assessment on the day I hit my drawdown, itās usually at least 24h after, because I want to have a fresh mind.
Once you have all the pieces of the puzzle, itās a question of waiting until you feel that youāre ready to go back to war. No room for emotions or weak people here. You fight, or youāre out. This is why itās CRITICAL to accept the drawdown and learn to live with it. Itās here, with you. It can come at any time. And every time itāll be here, you need to be fucking ready. Or youāll die on the felt.
From now on, there are two outcomes: you climb back to new all-time highs, or you keep losing $. I wonāt wait for another 10% dip in my Portfolio to restart the above process. If 15% is hit, Iām out for at least a week.
However, to the difference in what I can read sometimes, I donāt calculate my drawdown based on its most recent ATH but rather on some sort of average using the previous and current monthās ATH (not always the case, of course).
What does that mean?
Letās say my Portfolio had an ATH of $150,000 last month, and weāre now in the middle of the following month, and Iām sitting with $175,000. I wonāt use this $175,000 as my highest point to calculate my drawdown, but rather ($150,000 + $175,000) / 2 = $162,500. Why? Because Iām in a growth model. Iām ready to sacrifice 50% of my winnings on any given month to grow my account more aggressively if an A+ setup shows up. It also helps mentally during the month, as if I have a good start to it and start giving back some of the profit, Iām not āofficiallyā in a drawdown yet, based on my rules.
I have had a very fortunate 2022 so far and havenāt occurred a drawdown above 10% based on this rule.
As always, there is no perfect answer in trading, but this is what works for me so far. This is the beauty of trading; you can model your framework in a way it fits your personality and risk tolerance. You can be creative as long as you remain aware of the risks you take. Because when you hit a 50%+ drawdown, itās usually too late.
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Have a great weekend.
Love,
Retail ā¤ļø
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Apex is a community of traders founded by Darrell Martin, a rancher and day trader who has built a thriving community of traders into over 30,000 members in over 150 countries since 2008.
Thank you so much! I love reading you're articles! There is so much to learn and I love how positive you are. It's awesome reading some of your past mistakes because it let's me know I'm not the only one who goes through this. I'm hoping to journal and start doing some of the things you do so I can lesson the learning curve. I appreciate you š
Great article as usual šš»
Many good things to take from this