By Rob Colville on April 29, 2016 in
There are plenty of mistakes that we (hopefully) only make once: Like eating gas station sushi, for example; or trusting a politician; or perhaps dating a girl named Kristin! Now alas, from my own, personal experience, those decisions don’t usually end well, but mistakes do happen, and likewise, for traders, at some point, we all may have to feel the sting of a severe drawdown, too.
It’s rather strange, in fact, that most every veteran trader, and unfortunately, many new and inexperienced traders as well, have a story about their first (and hopefully only) severe drawdown. Maybe it’s something you’ve even been through yourself?
Some traders think back on a severe drawdown like it was a revelation or some kind of transformative experience…and for some, maybe it is. I’ll tell you though, taking a severe drawdown mainly just sucks, and it’s a painful wakeup call that’s tough to come back from…some traders never do.
That’s why today, I want to share with you a five-step process to put into place if ever you do sustain a severe drawdown in your trading. The hope is that, by doing these things, you’ll avoid further losses, overcome the initial shock, and make meaningful changes that will help you bounce back and return to trading armed with habits and proper risk controls that will keep you from repeating your initial mistake. So with that being said, let’s get started…
There’s only one urgent action that’s advisable on the heels of a severe drawdown, and it’s this: Whatever you do, don’t go ahead and take some other ill-advised trade while searching for “revenge” over a market that’s just done you wrong.
Simply put, make sure that you don’t further compound the damage by risking further losses. Translation: Stop trading immediately! Unfortunately, what’s happened is now in the past and entirely beyond your control, meaning that on the heels of a severe drawdown, your focus must shift towards the present and the future, and the factors that you can—and must—control going forwards.
Not to dwell on the negative, but in order to move forward and fix what may be a glaring problem, you do have to honestly and objectively assess what happened to ultimately result in a severe drawdown in the first place.
Were improper risk controls in place, or even worse, were no risk controls in place? Or, was it an unforeseen market move, like we saw when the Swiss National Bank (SNB) removed the long-standing peg between the euro (EUR) and Swiss franc (CHF)?
In cases like with the SNB, there may not have been much, or anything at all, that you could’ve done to prevent the severe drawdown. However, if you were using too much leverage, trading with excessive risk, or not managing risk to the very best of your ability, well then, you’ve just learned a costly and avoidable lesson in the value of risk control. Don’t take it lightly, and do take steps to document what went wrong and how you intend to fix it going forwards.
A monumental or transformative lesson in trading sounds like a perfect time to make an entry in your trade journal, doesn’t it? Document all that happened to cause the severe drawdown, complete with the chart, time frame, and trade parameters, and then more importantly, lay out clearly and completely how you intend to adjust your methods going forward to prevent a repeat occurrence.
Maybe it’s using technical analysis to place a stop loss in a sensible location, perhaps one that keys off of the current and prior bars or candles on the chart you’re trading. Whichever methodology you use can be up to you, but the point is to make sure that you document set trading rules and introduce incentives like a reward/punishment system to ensure that you’ll now follow them. Which reminds me…if you broke a rule in the first place that led to this severe drawdown, what’s your punishment for doing so?
Whenever introducing new rules or trading tactics, it usually pays to test them out in a demo environment first. As it happens, this may be convenient, because if your punishment for breaking the rules in the first place is that you have to suspend trading for a few days or a week, then you’ll have plenty of time on your hands to practice anyway!
Revert back to paper trading for the time being, and carefully apply your trading strategy, being especially mindful of risk and the new rules and risk controls that you’ve just implemented. It takes a large number of repetitions to make an action feel like second nature, so spend some time and honest effort on this, and only once you’ve built up a sense of comfort and understanding, and maybe restored some lost confidence in your overall trading strategy, should you begin planning your return to trading with real money.
Once your punishment and demo trading stint are both over, and you deem yourself strategically and psychologically prepared to resume trading, don’t just throw yourself into the “deep end” right from the start. Re-enter the markets by trading half size, by qualifying your trades even a little more stringently than usual, and by requiring ultra-clear signals, perhaps some element of added confirmation, and optimal reward/risk before trading.
Recognize that sustaining a severe drawdown is often a turning point in a traders’ career, and while it can be a meaningful stepping stone towards longer-term improvement, it also puts the trader in a vulnerable situation. Don’t just try to “shake it off” or “forget about it” and move on. Spend time and focus efforts on creating change and returning better off for it.
Take all the time you need before returning to the markets, too. Until you can return feeling confident, and like you’re truly over what has happened to you, don’t put real capital at risk. Make it your business to treat a severe drawdown as a learning experience and something you can build on, and it can become just that. However, treat it as a devastating loss from which you now must make up for financially and it could lead to more mistakes that could spell the end of your career. Choose learning and improvement, and take these strides towards trading better for the long term.
Remember, too, that when navigating uncharted territory like how to bounce back following a severe drawdown, sometimes it’s best to rely on those who have done it themselves! So if you want to learn more about managing risk, creating an effective stop-placement methodology, or just thinking more clearly and professionally about your trading, you can find a wealth of education and personalized insights for doing just that as a member of the Lazy Trader community. Click below for more info and to get started today!