Guard Yourself Against Drawdowns!
Every trader must guard himself against the drawdown, which refers to the percentage drop in his account size after one losing trade or consecutive losing trades.
For example, imagine that after losing a few trades in a row, your $20,000 account is reduced to $12,000; that would be a drawdown of 8,000/20,000 = 40%.
If I were to ask some new traders, “In order to be back up to $20,000, what percentage return do you need to generate?”, many would answer, “Since I lost 40%, I have to make back 40%!”
This couldn’t be more wrong! Note that after losing 40%, the trader now starts with a lower base, i.e. to undo the $8,000 loss, the return he needs to generate is 8,000/12,000 = 67%!
The more severe the drawdown, the harder it becomes to undo the damage, as shown in the attached chart.
A severe drawdown causes you to have to start with a much smaller base, thereby having to take higher risks to undo the damage. This is why many undisciplined traders, who do not systematically plan their trade sizes, find themselves going into a “downward spiral” when they suffer severe losses.
This is why I risk no more than 3 % of my account size per trade. In fact, new traders might want to risk no more than 1.5% to 2 % of the account size in any one trade. Sometimes, even with good trading strategies, you might suffer 3 or 4 consecutive losses. You need to ensure that the emotional impact of the resulting drawdown doesn’t damage you too much, so that you can recover (emotionally and financially) from the losing streak. This cannot be over-emphasized, for it distinguishes the profitable traders from the losing ones!
