Money and Portfolio Management pt. 2

Drawdown

Drawdown is simply the amount of money you lose trading, expressed as a percentage of your total trading equity. If all your trades were profitable, you would never experience a drawdown. Drawdown does not measure overall performance, only the money lost while achieving that performance. Its calculation begins only with a losing trade and continues as long as the account hits new equity lows.

Suppose you begin with an account of $50,000 and lose $10,000. Your drawdown would be 20%. On the $40,000 that remains, if you subsequently make $5,000, then lose $8,000, you now have a drawdown of 26% ($10,000 + $8,000 - $5,000 = $13,000, a 26% loss on the original equity stake of $50,000). But, if you made $15,000 after the initial $10,000 loss (increasing your account equity to $55,000), then lost another $8,000, your drawdown would be a 5.45% ($3,000/$55,000 = $47,000) drop from the new equity high of $55,000.

Maximum drawdown is the largest percentage drop in your account between equity peaks. It's how much money you lose until you get back to breakeven. If you began with $50,000 and lost $20,000 before getting back to breakeven, your maximum drawdown would be 40%. Keep in mind that no matter how much you are up in your account at any given time--100%, 200%, 300%--a 100% drawdown will wipe out your trading account.

Drawdown recovery The best illustration of the importance of money management is the percent gain necessary to recover from a drawdown. Many think that if you lose 10% of your money all you have to do is make a 10% gain to recover your loss. Unfortunately, this is not true.

Suppose you start with $50,000 and lose 10% ($5,000), which leaves you with $45,000. To get back to breakeven, you would need to make a return of 11.11% on this new account balance, not 10% (10% of $45,000 is only $4500--you have to make 11.11% on the $45,000 to recoup the $5,000 lost).

Even worse is that as the drawdowns deepen, the recovery percentage begins to grow geometrically. For example, a 50% loss requires a 100% return just to get back to break even.

Notice that as losses (drawdown) increase, the percent gain necessary to recover to breakeven increases at a much faster rate. This illustrates the difficulty of recovering from a loss and why money management is so important.  

Professional traders and money mangers are well aware of how difficult it is to recover from large drawdowns. Those who succeed long term have the utmost respect for risk. They stay on top by not taking huge risks. They control risk through proper money management. Sure, we all like to read about the Warren Buffet’s who parlay small sums into fortunes. What these stories do not mention the thousands of traders through lack of respect of risk lose their money and are wiped out.

Long losing streaks are possible, especially if the odds on a profitable trade are less than 50%. It is possible to have a profitable trading system but still have a streak of 10 losses in a row. If you start with an initial purchase of $1,000 worth of stock, and double the amount of money at risk after every loss , after 6 losses, your total capital loss would equal $32,000, after 8 losses - $255,000 and after 10 losses you would have lost $1,023,000. That means on the 11^th stock purchase, you have to buy over 1 million dollars of stock. And if you lost, you would be out two million dollars. Most of us do not have the bank roll for that type of activity. I fact I doubt most of us would risk 2 million dollars for a return of one thousand dollars. That’s a return of only .05%

Or, for a more realistic example; suppose your trading system has a historical drawdown of $10,000. You save up the $10,000 and begin trading the system. Almost immediately you encounter a string of losses that wipes out your account. The system then starts working again as you watch from the sidelines. You then save up the bare minimum and begin trading the system again. It then goes through another drawdown and once again wipes out your account.

Your "failure" had nothing to do with you or your system. It was solely the result of not being adequately capitalized. In reality, you should prepare for a "real-life" drawdown at least twice the size indicated in historical testing (and profits to be about half the amount indicated in testing). In the example above, you would want to have at least $20,000 in your trading account, and most likely more. If you would have started with three to five times the historical drawdown, ($30,000 to $50,000) you would have been able to weather the drawdowns and actually make money.

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