Depth and Length of a Drawdown Period
Beside the definition of drawdown in the previous post it can be also defined as the maximum loss of money that occurred between two equity high points of the same value, measured in percentage of equity. For example, if the Forex account balance reached $10,000 at one point, then it declined by losses through time till it became $9,000, and later it raised up again to $10,000, this means that the balance was exposed to a $1,000 (or 10%) drawdown, and the drawdown period is the time passed between the two equity high points of $10,000.
A drawdown risk can can be estimated by two values, the depth (of loss) and the length (of time), the most serious is the depth, while the most worrying to the traders and affecting their trading behavior is the length, as in live trading you may psychologically afford a drawdown of 10% for a couple of days, while you may completely lose hope if you experienced a drawdown of 5% for 3 months.
Drawdown Periods ADVANTAGES
The general impression is that drawdown periods are a negative impact on a Forex account, but this is not the full truth as any solid strategy can reasonably make profits during it while its weak traders are filtered out giving way to smart ones to gain their profits easily.
This is a science that studies the different effects of classical economics and behavioral psychology on each other using studies and researches for decades on the human brain and now there are many mightily authenticated books discussing the herd or weak traders emotion influences on their trading decisions in the live market, and how to smartly exploit these emotions to make profits.
WEAK traders main facts & criteria
- They reluctantly realize losses, but realize gains so quickly, so their accounts are at higher risk when exposed to losses while they can easily miss important profits when exposed to profitable positions.
- Their economic decisions are usually inconsistent and irrational even if they experienced the same scenario more than once.
- They usually expect the prices to revert in a mean by determining an imaginary long term average and expecting the prices to return to it, and this is why on volatility breakout or trend following strategies, they think they are buying expensive positions.
Talking about behavioral finance can take so many articles and won't fulfill, but let's focus on these two points:
- Behavioral finance isn't a considerable or even known aspect for those weak traders trading regimes, so they think that their decisions are always right depending on their gut feeling.
- Behavioral finance is well known and considerable by any smart trader. In fact he may not be considered smart before studying about it and get trained to go beyond his limitations. If not, he should at least understands his own brain and knows how to deal with it to maximally scale down the risks it might cause to his Forex account, beside that he well knows how to exploit the herd behavior to make more profits.
Smart and Weak Trader Reactions to Drawdown Periods
A weak trader, when experiences a drawdown period, his mode suddenly gets reverted and he feels sad and remorse with a flush of negative ideas and purposeless questions from his brain which answers don't lead to a recovery or even a partial recovery from the occurring losses and the worst is that they may get aggravated:
- Is this drawdown normal?
- I'll minimize the risk to pass this slope and raise it back later.
- What are the strategy other traders thinking to do now? I'll check forums, Facebook or others.
- It seems that this strategy is no longer profitable, I'll search for another profitable one.
- This strategy is poor and can't work in ranging markets as is the case now.
- The position is being opened for long time enough and still resistant to the strategy, I should close it then.
- The last 10 trades were lost and unrecovered by the strategy, I should close this trade manually.
- How long would the market stay in this condition? for months? years?
- I should stop everything now and restart after improvement of the market conditions.
- I'm a loser, always! :(
In fact, a weak trades is poor in knowledge and popper tools that enables him to face a drawdown period in the right way and he is always very confused and suffering much pain!
On the other hand. smart traders have many opposite behaviors to those of weak ones, the most important of which is that they employ a trading plan, which is necessary with automated trading and it can be outlined by him while he is calm with no risks.
A trading plan takes many aspects into consideration, but regarding drawdown, it should at least have the following:
- All of the strategy statistical data in details as the expected profit, the expected drawdown, the maximal drawdown depth and length, the average win percentage, the reward to risk ratio and more.
- Different positive and negative scenarios with the decisions should be taken in each of them as in cas of extensive and / or deep drawdown periods, whether to trade during Christmas or summer times, whether to close all or some positions before weekends or keep them opened, a past losing year and the future plan, a plan for funding and withdrawing profits and more.
- Determining the very predictable worst scenario which should be considered as the red line which if passed by the strategy, this would be a sure failure and a crucial decision must be taken as stopping the strategy, adapting the parameters and so on. You can calculate this red line in several ways as using double the maximum historical drawdown, Montecarlo simulations, regression lines multiplied by x times the equity curve standard deviation and more. You just need a number for this, the more important is to get it written in your trading plan.
On this way, a smart trader can have a detailed map of the investment he is doing while trading live, so he can analyze the live behavior of the strategy at any time and compare it with his predetermined scenarios including the worst one and perform the predetermined action he has set in his plan against each scenario, even if nothing should be done, it's needed to be written.
The Out of Plan Scenarios
Unexpected situations and what to do then, should be covered by the plan too. You should extremely exclude your gut feeling as a source of your decisions if something unexpected has happened, it's safer to refer to your planning and analysis board.
A sudden serious problem as an abrupt deep drawdown, when precisely and carefully analyzed, it's often not a so important problem and is within the predicted statistics and many similar previous periods have really took place.
New and first time events are not uncommon, this is an any market rule as thee market conditions are always changing and new ones are constantly appearing in any time frame, some of them are highly aggressive and may last for a long time and the others aren't.
A firm strategy often can be adapted to new market conditions by using its built-in analytic and optimization techniques, the smarter they are the more powerful the strategy is and the easier for it to deal with most of the market changes as some may be still tough with drawdown periods. All of this should be normal and similarities might have already happened in the past.
If you realized that what is happening now is normal while others are considering it serious, you won't be worried and will have the enough behavioral stability to take the suitable decision in the ideal time. You can do this if you have a trading plan with a full analysis of your trading strategy; a smart traders quality.
Lack of knowledge and planning will make you use the least excuse to stop trading and relax your mind which is full of sadness, regret, negative thoughts and aimless questions trying to close what you think is the cycle of subversion your own trading account; a weak traders quality.
Once the weak traders are filtered out of the market, higher chances for the smart traders to get its new equity high emerge. If a weak trader decided then to jump on board again, he would be too late, but he might benefit from the next drawdown period.