THE ULTIMATE CHART ANALYSIS
How to Handle Drawdowns: Incase the Strategy goes Against your Prediction.
Your strategy will inevitably go through a Drawdown. And there's nothing you can do about it to stop that. However, you can learn how to survive it!
Today I will give you actionable steps, that you can use for the next time the market hit your strategy and you feel that everything is going wrong.
Let's start with an idea of what a drawdown is, and why drawdowns happen.
There are an infinite amount of trading strategies and tools that people use to trade and take advantage of specific market conditions.
Some traders are better in trending markets, they trade breakouts. Other traders feel more comfortable in ranging markets, where they trade quick reversals on key levels.
The Math is simple here. Trending strategies will have a poor performance on ranging markets, while reversal strategies will have a poor performance on trending markets.
Detecting the beginning and end of trending cycles or ranging cycles, is blurry. So, if you agree with that, as I do, you can expect your strategy to start failing at some point. And that's the beginning of the drawdown. (This is true for the best traders in the world, as for the worst traders in the world. Nobody scape drawdowns, the quickest you accept this, the faster you can learn how to handle them properly)
So let's start by saying that drawdowns are situations where your strategy experiences a lasting decline in performance, even if you are doing everything perfectly. Drawdowns, happen because strategies are made to take advantage of specific anomalies that can be found in one part of the market cycle, and when that market cycle finishes, or changes, your strategies become less accurate.
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It's important that you become aware of the Psychological consequences of Draw Downs, so you can have a countermeasure for this. Let's take a look at the most common ones:
1) Decrease in confidence (constant negative thoughts about your system)
2) Fear of entering the next trade.
3) Thinking about changing things in your strategy (deviations from the original plan)
4) Thinking about modifying the risk you are using to cover losses quicker.
5) Ceasing your trading execution, and looking for a new strategy.
ALL THESE ITEMS, are the main situations you may start feeling when going through a drawdown. IF you are going through that, it's important that you understand that you are under a delicate emotional state, where your confidence is low, and you are prone to make more emotional decisions that 99% of the time, tend to increase the drawdown.
So the way we handle drawdowns is by having logical and systematic processes in place instead of emotional ones.
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Here you have actionable steps to handle drawdowns:
STEP 1: You handle drawdowns by getting ready before they happen, not when they are happening.
This is true for almost all disciplines, not only for trading. Airplanes have clear plans in case things start going wrong, instead of figuring out the problem at the moment, pilots go to the manual book, and use the template for this situation, plus the fact that they trained those situations several times in simulations.
So, if you want to understand what a drawdown situation looks like in your strategy, you MUST go into the past, and when I say this, I'm not saying making a 3 week backtest. You need to go as far as you can in the past, to find that exact moment where your strategy is not working as expected.
How many consecutive stop losses do I have? 3? 5? 15? 20?
How long does this period last until everything goes on track again? 1 month? 3 months? or a year?
These are the kind of answers you are trying to solve. When doing a backtest you are trying to understand two things. The first one is if your strategy has an edge. The second one is how hard you get hit when things go wrong!
STEP 2: Work your risk management around the stats of your system. Imagine we reach the following conclusion "I have a system, that executes 10 setups
Today I will give you actionable steps, that you can use for the next time the market hit your strategy and you feel that everything is going wrong.
Let's start with an idea of what a drawdown is, and why drawdowns happen.
There are an infinite amount of trading strategies and tools that people use to trade and take advantage of specific market conditions.
Some traders are better in trending markets, they trade breakouts. Other traders feel more comfortable in ranging markets, where they trade quick reversals on key levels.
The Math is simple here. Trending strategies will have a poor performance on ranging markets, while reversal strategies will have a poor performance on trending markets.
Detecting the beginning and end of trending cycles or ranging cycles, is blurry. So, if you agree with that, as I do, you can expect your strategy to start failing at some point. And that's the beginning of the drawdown. (This is true for the best traders in the world, as for the worst traders in the world. Nobody scape drawdowns, the quickest you accept this, the faster you can learn how to handle them properly)
So let's start by saying that drawdowns are situations where your strategy experiences a lasting decline in performance, even if you are doing everything perfectly. Drawdowns, happen because strategies are made to take advantage of specific anomalies that can be found in one part of the market cycle, and when that market cycle finishes, or changes, your strategies become less accurate.
--------------------------------------------------------------------------------------
It's important that you become aware of the Psychological consequences of Draw Downs, so you can have a countermeasure for this. Let's take a look at the most common ones:
1) Decrease in confidence (constant negative thoughts about your system)
2) Fear of entering the next trade.
3) Thinking about changing things in your strategy (deviations from the original plan)
4) Thinking about modifying the risk you are using to cover losses quicker.
5) Ceasing your trading execution, and looking for a new strategy.
ALL THESE ITEMS, are the main situations you may start feeling when going through a drawdown. IF you are going through that, it's important that you understand that you are under a delicate emotional state, where your confidence is low, and you are prone to make more emotional decisions that 99% of the time, tend to increase the drawdown.
So the way we handle drawdowns is by having logical and systematic processes in place instead of emotional ones.
--------------------------------------------------------------------------------------
Here you have actionable steps to handle drawdowns:
STEP 1: You handle drawdowns by getting ready before they happen, not when they are happening.
This is true for almost all disciplines, not only for trading. Airplanes have clear plans in case things start going wrong, instead of figuring out the problem at the moment, pilots go to the manual book, and use the template for this situation, plus the fact that they trained those situations several times in simulations.
So, if you want to understand what a drawdown situation looks like in your strategy, you MUST go into the past, and when I say this, I'm not saying making a 3 week backtest. You need to go as far as you can in the past, to find that exact moment where your strategy is not working as expected.
How many consecutive stop losses do I have? 3? 5? 15? 20?
How long does this period last until everything goes on track again? 1 month? 3 months? or a year?
These are the kind of answers you are trying to solve. When doing a backtest you are trying to understand two things. The first one is if your strategy has an edge. The second one is how hard you get hit when things go wrong!
STEP 2: Work your risk management around the stats of your system. Imagine we reach the following conclusion "I have a system, that executes 10 setups
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THE ULTIMATE CHART ANALYSIS
How to Handle Drawdowns: Incase the Strategy goes Against your Prediction.
per month" and the worst-case scenario I have found is 20 consecutive stop losses during 2 months. What I would personally assume is that 20 consecutive stop losses can be 30. So how much capital percentage should I risk on this system so I don't get knocked out if this TERRIBLE scenario happens.
The answer for me would be 1% per setup. Under the assumption of this unique scenario, I would be 30% down, which is something acceptable, compared to the drawdown of conventional investment vehicles like S&P500 where we observed those kinds of declines, in the last years. The main point here is that you need to adapt the risk you are using on the strategy, to the stats of it, and your risk tolerance.
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Let's recap the key aspects of this post.
1) Drawdowns are inevitable, your strategy will be hit by this scenario eventually.
2) Drawdowns cause an emotional disturbance and are the main reason why people make really bad decisions.
3) We handle drawdowns by getting ready in advance. Through backtest, we can understand the edge of our strategy and the worst-case scenarios.
4) We adapt the risk of our strategy, by considering a terrible scenario, like 30 consecutive losses.
This will not eliminate the feeling during this period, but it will bring you a work frame to make logical decisions based on data, instead of emotions. Implementing this type of thinking will make your strategy more robust, it will help you go through these situations, and most importantly it will protect you from making stupid things with a strategy that has an edge, and actually works!
Thanks for reading!
The answer for me would be 1% per setup. Under the assumption of this unique scenario, I would be 30% down, which is something acceptable, compared to the drawdown of conventional investment vehicles like S&P500 where we observed those kinds of declines, in the last years. The main point here is that you need to adapt the risk you are using on the strategy, to the stats of it, and your risk tolerance.
--------------------------------------------------------------------------------------
Let's recap the key aspects of this post.
1) Drawdowns are inevitable, your strategy will be hit by this scenario eventually.
2) Drawdowns cause an emotional disturbance and are the main reason why people make really bad decisions.
3) We handle drawdowns by getting ready in advance. Through backtest, we can understand the edge of our strategy and the worst-case scenarios.
4) We adapt the risk of our strategy, by considering a terrible scenario, like 30 consecutive losses.
This will not eliminate the feeling during this period, but it will bring you a work frame to make logical decisions based on data, instead of emotions. Implementing this type of thinking will make your strategy more robust, it will help you go through these situations, and most importantly it will protect you from making stupid things with a strategy that has an edge, and actually works!
Thanks for reading!
👍3
FOMO is a P&L Killer! At its core FOMO is a fear. The problem is not that we missed the trade, it’s that our brains perceive that missed trade as a threat to our future, our success, our reputation. When humans are afraid of something, or see a threat, it produces anxiety. This fear takes blood away from the part of the brain where higher level thinking takes place and sends it to the part that impulsive thinking lives. There WILL be poor decision making under the influence of anxiety. The key to solving this issue is to take the threat out of the situation.
Solutions:
Taking a break from the screen is healthy but it is not a long-term fix. Brett explains how to train in exposure therapy (His presentation explains this in greater depth.) Slow breathing and visualization are more adept at battling FOMO. If you can visualize a calming place or situation and pair it with that fear, daily practice and dedication will prevent blood flow to the impulse zone. Gradually, when FOMO comes around, you will experience feelings of safety. Combined with expanding your time of reference, understanding, and acknowledging FOMO will make those events look like potholes on a long highway.
Missing a trade is unfortunate, but will it end my career? No. Will buying at the top, and then being so irate that I add to a losing trade and forgo stop orders end my career? It might. Will I be thinking clearly on my next trade with a fresh mistake permeating my thoughts? No.
The best motivation to avoid FOMO is to develop emotional hate towards the negative consequences of it. In the fullness of time, the desire to avoid negative outcomes becomes self-reinforcing with repetition and therefore cements as an internal priority. This works across the board in other life scenarios as well.
Tapping into other motivations besides P&L is one that really hit home with me as well. Brett dives into the desire to learn and grow as a greater motivator than just P&L alone. This addition will create a dual purpose to each trade. You are diversifying your outcome! If you come away from a trade with a negative P&L, but with a positive learning experience, you are building your Learning Capital. With time under this premise, your Learning Capital will be indistinguishable from your monetary statement.
Instead of tying your value as a trader strictly to your P&L, tie your value to your consistency and risk management. The magnitude of your P&L is nothing without consistency. Risk management begets larger positions, lower drawdowns, and an overall better quality of work life.
A Day comes with myriad experiences. Create a diversified life with people and activities that fulfill you outside of trading and your trading will improve. Reminding yourself daily of this is important.
Tying all of this together is the practice of keeping a daily ABCD Journal.
A- Activating Event – What got you upset? - Missing the trade in this case.
B- Beliefs about the event – Little voice in your head – Why is this upsetting to you? “Other people are getting ahead of me, I’m not as good as they are”
C- Consequences from the event – How does negative thinking affect your subsequent trading? I’m so upset about missing the opportunity I go ahead and miss the next one!
Becoming proficient in ABC will allow you to recognize the triggering event in real time. You begin to identify the negative beliefs and become a pro at understanding the magnitude of the consequences. You can change the pattern of your behavior because the consequences are so front and center.
D- Disputation- You are talking back at that negative thinking. How would you talk to someone you care about who is in that situation? Mentoring a teammate that missed a big play involves constructively lifting them up and helping them learn from it with a comforting tone. You aren’t going to beat them up.
Taking a break from the screen is healthy but it is not a long-term fix. Brett explains how to train in exposure therapy (His presentation explains this in greater depth.) Slow breathing and visualization are more adept at battling FOMO. If you can visualize a calming place or situation and pair it with that fear, daily practice and dedication will prevent blood flow to the impulse zone. Gradually, when FOMO comes around, you will experience feelings of safety. Combined with expanding your time of reference, understanding, and acknowledging FOMO will make those events look like potholes on a long highway.
Missing a trade is unfortunate, but will it end my career? No. Will buying at the top, and then being so irate that I add to a losing trade and forgo stop orders end my career? It might. Will I be thinking clearly on my next trade with a fresh mistake permeating my thoughts? No.
The best motivation to avoid FOMO is to develop emotional hate towards the negative consequences of it. In the fullness of time, the desire to avoid negative outcomes becomes self-reinforcing with repetition and therefore cements as an internal priority. This works across the board in other life scenarios as well.
Tapping into other motivations besides P&L is one that really hit home with me as well. Brett dives into the desire to learn and grow as a greater motivator than just P&L alone. This addition will create a dual purpose to each trade. You are diversifying your outcome! If you come away from a trade with a negative P&L, but with a positive learning experience, you are building your Learning Capital. With time under this premise, your Learning Capital will be indistinguishable from your monetary statement.
Instead of tying your value as a trader strictly to your P&L, tie your value to your consistency and risk management. The magnitude of your P&L is nothing without consistency. Risk management begets larger positions, lower drawdowns, and an overall better quality of work life.
A Day comes with myriad experiences. Create a diversified life with people and activities that fulfill you outside of trading and your trading will improve. Reminding yourself daily of this is important.
Tying all of this together is the practice of keeping a daily ABCD Journal.
A- Activating Event – What got you upset? - Missing the trade in this case.
B- Beliefs about the event – Little voice in your head – Why is this upsetting to you? “Other people are getting ahead of me, I’m not as good as they are”
C- Consequences from the event – How does negative thinking affect your subsequent trading? I’m so upset about missing the opportunity I go ahead and miss the next one!
Becoming proficient in ABC will allow you to recognize the triggering event in real time. You begin to identify the negative beliefs and become a pro at understanding the magnitude of the consequences. You can change the pattern of your behavior because the consequences are so front and center.
D- Disputation- You are talking back at that negative thinking. How would you talk to someone you care about who is in that situation? Mentoring a teammate that missed a big play involves constructively lifting them up and helping them learn from it with a comforting tone. You aren’t going to beat them up.
🧩👉 FOUR SIMPLE STEPS TO MAKING YOUR ULTIMATE STRATEGY:
Introduction
How many times did you find a perfect strategy giving great results in backtest but wasn't working for LIVE trading?
This effect is due to "overfitting" your past signals giving great historical results in a past environment.
Overfitting means you're forcing the results to look great; hence not realistic; knowing the historical price action.
Unfortunately, new traders don't know how random financial markets could be.
Then, a backtest with very controlled and precised conditions is often irrelevant for real/live trading.
Building a trading system is like solving a puzzle.
We don't define the entries and exits separately - entries are defined relative to the exits and vice-versa.
Imagine a RubixCube where solving one face of the cube could mess up with the other faces of that cube.
Introduction
How many times did you find a perfect strategy giving great results in backtest but wasn't working for LIVE trading?
This effect is due to "overfitting" your past signals giving great historical results in a past environment.
Overfitting means you're forcing the results to look great; hence not realistic; knowing the historical price action.
Unfortunately, new traders don't know how random financial markets could be.
Then, a backtest with very controlled and precised conditions is often irrelevant for real/live trading.
Building a trading system is like solving a puzzle.
We don't define the entries and exits separately - entries are defined relative to the exits and vice-versa.
Imagine a RubixCube where solving one face of the cube could mess up with the other faces of that cube.