Trading Techniques: Managing a Drawdown

Drowning in the Market

Learn how to manage a significant drawdown in your trades in the Forex market. It is important to  maintain a healthy trading psychology bur actions speak louder than words. Our technique is designed for experienced traders.

Unfortunately, many novice and experienced traders suffer when their perfected trading strategy is falling apart, stripped off its dignity to the almighty bulls and bears in the FX territory.

Despite the armour of sophisticated risk management techniques and the helmet of psychology, the rusty bullet of arrogance will pierce it all. The heroic feeling you can survive those harsh times and yank yourself out the sizzling quicksand will ultimately lead to your inevitable fate.

Managing a significant drawdown is one of the toughest times thousands of the traders experience. Most are paralyzed to their keyboard, hoping God will reveal itself within the Japanese candlesticks, creating a magical window to escape the infamous margin call death-trap.

The market is bulletproof to religions, cultures, superstitions and especially to arrogance. If you find yourself sucked into the market’s world of fantasy you are about to begin your journey in the most extreme hills of psychology. To assist you in such dreadful times we have created this article from joy, sorrow and regrets rather than diving into the theoretical world, which unfortunately does not serve us as traders in global markets.

Drawdown Management

When your investment is struck with a lethal drawdown, your smooth ego is blistered beyond recognition. Your humane antidote is to reject reality and uplift your mind above the market. No trading strategies, no risk management, no margin calls and no leverage. A place we call Eden.

An overdose of ‘Eden’ brought many traders to their knees as they increase the market exposure in an attempt to pull off an Indian-Jones act but from our experience, such a route ends in a substantial loss and horrific psychological effects. The first step that must be done if you are experiencing a high drawdown is to shut down your trading platform. You cannot allow yourself to be mesmerized by the bobbing Japanese candlesticks, mocking your open trades.

You are likely to ponder how you found yourself in such a scenario and what could have been done to avoid it, another humane feeling you must eradicate. Under such stress no rational thinking can be exercised. The mist of desperation will cloud your rational mind, spreading its tentacles though your body into your hands, which will in turn take corrosive actions by disfiguring your protective stops or pumping cleansed liquidity that will only catalyse the inevitable.
Detach yourself from the market for at least a couple of hours.

The cooling period will prevent you from causing further damage to your trading account. Do not monitor the rates or any market related events.  We will not instruct you how to spend your time but do not think about the drawdown, how you found yourself in it or how to resolve it. When you return to your trading platform, if you were stopped out understand that if you were in the trading platform it is highly likely you will either increase the leverage or displace your stops. The couple of hours prevented you from taking these harmful actions.

A Healthy Risk Management

After a couple of hours we suggest you will open your trading platform and begin your assessment. Revise your trading strategy, explore whether you obeyed the strategy’s rule in every trade. Trades that violated the rules should be treated in the following manner. Many will tell you to just close the trade and move on, this is wrong and we find a great difficulty to believe such a statement comes from a seasoned trader.

Whether the market is within a close proximity to your protective stops or do have some distance (mostly trades that were intentioned for the long-term) the stop loss orders must be readjusted. Use a 15min chart to reset your stops, you cannot afford a deeper loss.

If readjusting the stops will only increase your market exposure, shift the stops for only half of the trades.  If there is only one trade we believe the stop should be widened based on a 15min chart. Your exposure is likely to be increased by several pips (less than 25 pips on most occasions) but there are two advantages for imposing such actions.

If protective stop is triggered you will know you have done everything you can to ‘save’ the trade, which is a crucial psychological effect when you resume trading. The second advantage is that the trade has been readjusted to current market conditions, which increases the odds of the price distancing itself from your stop loss, thus lowering the drawdown.

If the market turns in your favour but the trade or trades are still in a loss, this is time to begin realizing partials with a loss. It must be done in order to minimize your market exposure. It is difficult to provide guidelines as it greatly depends on the trade size and accumulated negative pips.

If the price recovers by 20 pips, start realizing partials with a loss, preferably 5.0% of the trade. Combine the 15min chart with the hourly chart and continue realizing additional partials of 5.0% and continue raising the stops but as you have gained some distance from the market use the hourly chart for determining at which price levels to layer your stops. If 45% of the problematic trade has been liquidated with a loss and the trade is still in the negative we suggest stopping further liquidation until the trades near their entry.

When that happens, liquidate the remaining 45% without any hesitation. You have then survived the drawdown and may begin concluding the steps to prevent another visit into the dark side of the market.  We would like to repeat that even if the trades were stopped out before reaching the entry understand you have successfully minimized your loss and done everything in your power to recover.

Existing Trades Imbalance

For the trades that were in line with your strategy you can leave in the market as the exposure will be minimized from the toxic trades. However, if there is an imbalance, meaning, the trade size of the positions that you did not deviate from based on your strategy  account for 90% of the open trades or if all trades were in line with your strategy, a harsher approach must be taken.

You cannot afford to place any trades until the drawdown is reduced. Revise the current market conditions and determine if your direction (long or short) is still relevant. If not and you there is a great distance between your stops and current price, we would suggest to liquidate 20.0% of the open trades in total. If the stops will be triggered, you have prevented a steeper loss.

By doing so you are freeing some margin that will allow you to focus on new trades. If the market is near your stops, readjust the stop based on the 15min chart we discussed earlier for just 50% of the trades.

We do not suggest to act on all trades if they were executed based on your trading strategy and there is a technical reason why you chose to place the trades at these levels. We are aware that by doing so your market exposure increases but the psychological effects are extremely important to resume trading once the drawdown has been moderately reduced.

If you ask why not do act within the first couple of hours, most traders’ mind will be poisoned by the excessive drawdown. It may have terrible repercussions which will be beyond repair.

If you consider our option you will notice that if the market will turn against you the loss will be smaller while at the same time you are freeing some margin for future trades, perhaps even trades you can place in parallel to established positions if the drawdown has been significantly reduced. This is how you manage high drawdown as you constantly focus on future trades. Minimizing your market exposure is extremely important if you wish to remain in the market for a long period of time.

The Alternative

If you are confident in your trading strategy as it has proven itself for a substantial period of time there is an alternative. Carefully revise the technical outlook of the given instrument. If the trend has not changed,  have faith in your strategy but actions must be taken. Look for technical entries on a shorter time frame to the opposing direction of your existing trades. When you have discovered an entry hedge the trade.

Determine in percentage points how much of the total trades you are willing to hedge. Similar to the above we cannot supply guidelines but we view 15.0% as the maximum  amount. Your exposure was now reduced by 15.0%.  If the market trades against your existing trade the hedged trade will be in a profit, which may be realized to reduce your net exposure. This will acquire more margin for placing new trades in the market.

Actions must be taken to tame the beastly drawdown or suffer the consequences. If you or your strategy are relatively new we  do not suggest to employ hedging to minimize your exposure. If conducted incorrectly it could enforce a margin call in your account. Do not hedge unless you are an experienced trader and are familiar with hedging strategies.

We hope this technique will serve you in trading the Foreign Exchange market as it is our goal you will conquer any negative events and literally rise from the ashes, regaining your confidence and increase your  Return on Investment (ROI) in global markets.