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.

Factor Membership is now available.  You could consider your membership in the Factor Service as just one more trade. If the Factor Service is not of value to you, well, it is just one more trade that did not work.   Through the Factor Service I endeavor to alert novice and aspiring traders to the many pitfalls you will face – and to offer advice on overcoming those pitfalls. My goal is to shoot straight on what trading is all about.  For more information, visit the home page here.  Or watch my 30 minute webinar where we cover the Factor service in depth.

 

 

 

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