What trading over the course of five different decades has taught me about drawdowns

Traders talk a lot about Trading Drawdowns. But what are they exactly? How are they measured? What do they mean? Can they be prevented? If not, how does a trader deal with them.

In the world of futures and forex, Trading drawdowns are measured based on month-end to month-end net asset value (or nominal account value). I know a number of traders who will measure drawdowns on a week-ending basis. I really do not know many traders who measure drawdown levels on a day to day basis. I was clipped today by about 170 basis points (1.7%), but that is not a drawdown. Day to day asset volatility does not represent a drawdown.

It is especially dangerous (from an emotional perspective) for novice traders to be intraday equity watchers. This is NOT a habit you want to get yourself into. As a chartist, I want to trade the charts, not my equity level. I do not want intraday — or even day to day — volatility in equity balance to affect my judgement.

The question a chartist should ask is: “Did today’s price action do damage to the technical case in a market?” Whether a position lost money is not the issue — nor should it be. I will tell you that every position I held today except one lost money. But not a single position experienced technical damage. If a trade is not digging into my pocket or experiencing technical damage, and if I am not over leveraged, then why should I pull the escape hatch?

I know traders who have “circuit breakers.” whereby if they reach a certain daily loss level they liquidate all positions. For me, a daily loss of 3% or more would force some examination of my positions. But, the chances are great that a daily loss of 3% of capital or more is an indication of being over leveraged, and that is a separate (but more deadly) issue.

Drawdowns are a fact of life for a trader. They happen. There will be bad days and bad weeks and bad months, and periodically even a bad year. A losing day/week/month is not an indictment against a trading plan. In fact, drawdowns are to be expected and a trader must learn to take them in stride without pulling the escape hatch whenever a position turns into a daily loser.

A benchmark metric maintained by many professional traders is their Calmar ratio. The Calmar ratio is calculated by dividing the worst drawdown (month-ending basis) into the average annual rate of return for some measure of time. A rolling three-year period is the most frequent time measure for determining Calmar. A Calmar ratio of 2.0 is considered outstanding — 3.0 is world class. Some short gamma traders (naked options sellers) can generate Calmar ratios of 5.0 or even higher — that is, until they go broke, which they eventually will.

The practical implication of a Calmar ratio of 2.0 is that to achieve an average annual ROR of 30% you will likely experience a worst-drawdown of 15% or greater (month-ending). Keep in mind that a month-ending worst drawdown of 15% probably equates to a week-ending worst drawdown of 20% or greater.

Now, if your trading approach frequently experiences daily equity swings of 3% or more, then you have some issues that need to be dealt with. But, equity swings less than 2% daily (or 5% monthly) must be expected.

If you cannot handle Trading Drawdowns, then my advice to you is simple — quit trading and take up gardening or knitting.

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