There are plenty of mistakes that we (hopefully) only make once. Like eating gas station sushi or trusting a politician! Those decisions do not usually end well. Trading mistakes happen, and we all may have to feel the sting of a severe drawdown, too.
It is rather strange that most disciplined traders and many new traders will have a story about their first severe drawdown. Maybe it is something you have even been through yourself?
Some traders think back on a severe drawdown like it was a revelation or some kind of transformative experience. Taking a severe drawdown mainly just sucks. It is a painful wake up call that's tough to come back from.
That is 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 losing trades. This can be achieved by meaningful changes such as proper risk management!
Takeaways
Learn to to use disappointment to your advantage
Are you prepared to become a risk manager?
Find out how reducing your losses increases your gains
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There is only one action that is advisable on the heels of a severe drawdown, and it is to take a break. Go and walk around the block. Resist the urge to trade again! Simply put, make sure that you do not further compound the damage by risking further losses. Unfortunately, what has happened is now in the past and entirely beyond your control. This means that on the heels of a severe drawdown, your focus must shift towards the present and the future. You should focus on the factors that you can—and must—control going forwards.
Do not to dwell on the negative. In order to move forward and fix what may be a glaring problem, you do have to honestly and objectively assess what happened. Ultimately you will often find (your) human error was involved. Were improper risk controls in place, or even worse, did you not consider the risk adjusted return? 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 to prevent the severe drawdown. However, if you were trading on margin and therefore using too much leverage, you have learnt a lesson about excessive risk. Next time you have some new trade ideas, consider using the risk reward ratio. Do not take it lightly, 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. Document all that happened to cause the severe drawdown. Complete this with the chart, time frame, and trade parameters. Importantly, lay out clearly and completely how you intend to adjust your methods going forward to prevent a repeat occurrence.
Maybe it is 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 are trading. Whichever methodology you use can be up to you, but the point is to make sure that you document set trading rules. You should introduce incentives like a reward/punishment system to ensure that you will now follow them. Which reminds me…if you broke a rule in the first place that led to this severe drawdown, what is your punishment for doing so?
Whenever introducing new rules or trading tactics, it usually pays to test them out in a demo environment first. Your punishment for breaking the rules in the first place maybe that you have to suspend trading for a few days or a week. You will have plenty of time on your hands to practice! Revert back to paper trading for the time being, and carefully apply your trading strategy. Be mindful of risk and the new rules and risk controls that you have just implemented. It takes a large number of repetitions to make an action feel like second nature. Therefore spend some time and honest effort on this.
Once your punishment and demo trading stint are both over, and you deem yourself strategically and psychologically prepared to resume trading, do not 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. You should also require ultra-clear signals such optimal reward/risk before trading.
Recognize that sustaining a severe drawdown is often a turning point in a traders' career. While it can be a meaningful stepping stone towards longer-term improvement, it also puts the trader in a vulnerable situation. Do not 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 are truly over what has happened to you, do not put real capital at risk. 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.
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