Every trader will have to go through a drawdown from time to time. The key is how you deal with it. In this article, we want to address various aspects in order to better deal with a drawdown. The causes, changes in behavior, the system, and, last but not least, an extensive analysis of the drawdown and thus of the last trades play an important role.
Drawdown by changing your own trading
Especially with beginners, a drawdown does not arise from the usual market movements, but often from mistakes in their own actions. 3 or 5 losing trades in a row is nothing unusual, but beginners tend to make more trades or increase the risk in precisely such phases, in the worst case even both at the same time. Such a drawdown is self-induced and requires hard work on the mindset because the cause is not systemic or bad luck.
Basically, we always recommend working according to a crystal-clear set of rules, which leaves as little room for interpretation as possible.
Drawdown by a strategy
First of all, you should always know which trades and strategies the drawdown comes from. Often it is only one of the strategies used that causes the overall drawdown. This essential aspect now needs to be analyzed more closely.
Any strategy, however good, will run into a drawdown. It is for this very reason that it is important to test every strategy thoroughly before applying it. You can do this either with software or manually. We recommend testing at least 100 simulated trades, ideally covering all 3 market phases, i.e. upward, downward and sideways market, provided the strategy allows trading in all phases.
If it is known that a drawdown can cause a loss of X% with fixed money management, one can mentally adjust to it much better and accept it as part of the strategy.
If you reach the borderline level when applying the strategy or even exceed it, this does not mean that the backtest was wrong. It can always happen that the past cannot be continued at 1:1. If the maximum acceptable loss has been reached, you should see whether the conditions or the environment for the strategy have changed and whether this has triggered the drawdown. If this is the case, you should either pause the strategy or adjust the money management.
In a few cases that have to be very well justified, you can sit out the excessive drawdown, as the current market environment creates a very rare framework that will soon normalize again. It is certainly better and, above all, mentally easier to stop using the strategy.
Correlation as a cause of a drawdown
Again, this is more of a mistake made by beginners. Many traders use 2 or more strategies and pay attention to the respective money management of individual strategies. It is only in the drawdown that they notice that both strategies have a high correlation to one another and thus the overall drawdown is being pushed. The overall portfolio of strategies should always have coherent money management.
Our current drawdown and analysis
We recently had a relatively large and severe drawdown.
In just over a week we had to give up 15%. But this has never unsettled us or made us doubt our strategies. Much of the unrealized losses stem from the rapid rise in implied volatility. We have multiple positions and different strategies that sell this implied volatility. We are aware of the risk of correlation and we accept it.
We cannot rule out the possibility of another drawdown that could possibly reach 20%. Then we will again carry out a thorough analysis and see whether we want to intervene or take the risk with a positive expected value.