Think Like A Trader Blog

Thursday, 6 August 2015

The Importance of Drawdown Rules When Trading

Having drawdown rules is one of the most important things I have learned since I began trading. Bad days happen to us all, but allowing a bad day to turn into a disastrous one is the difference between a professional and an amateur. When losses come, they don’t feel good, no matter how seasoned you are. And they do come, because losses are inevitable. It is the price of trading, your dealings with probabilities.

The problems arise when you get emotional about your losses. It can be frustration, anger or fear, it really doesn’t matter, because the outcome is the same – you begin to make mistakes, to take trades which fall outwith your trading rules. You might hear your inner voice speak up and say, well you just went short and it didn’t work, so go long quickly, catch this move and make back that loss. Or it may chirp up and inform you that there’s a perfect rising wedge forming, and yes, you don’t trade rising wedges, but this one’s so obvious and perfect, you can do it once and make back some of your money.

This happens. And at the beginning of your trading journey you will inevitably follow these suggestions, and countless others, and rack up losses. If you’re reading this then you’re at an advantage in that you’re actively seeking to learn how to combat all of the problems with your trading. Most people just keep repeating their errors until they run out of capital.

It doesn’t matter how long you’ve been trading for, if you haven’t built trading discipline, you will not be successful long term. Build yourself a rule set that you adhere to. Your trading system, sure, but more than that. Understand that your emotions can be powerful and can lead you toward disaster when trading. I would advise having drawdown rules.

I have drawdown rules. It’s very simple. If I have two losing trades in a row, I’m done for the day. This very rarely happens for me, but it does on occasion (and it used to happen all the time!). This is because I understand that after two losing trades, my judgment begins to slip. I think about making the money back rather than finding my perfect entry. My internal chatter starts suggesting ‘quick-fix’ trades I could take just this once in order to make the money back.

This is a recipe for disaster, please believe me. So I have rules that suit my personality. Two losses in a row and the computer is turned off and my day is finished. Frustrating when it happens, but necessary. Because I’ve been through the stage of chasing the markets and being sucked into the screen where I don’t even know what I’m doing any more, I’m just trying to catch a move, any move, to make money.

Your rules may be different. It may be one loss and you’re finished. That may suit your personality and your trading system. Mine is two trades purely because I know I have only a very small chance of losing two times in a row. And if I DO lose twice in a row, it is better for my account to walk away and come back the next day.

Here’s a quick example – today is ‘super Thursday’, according to the news. Bank of England Governor Mark Carney is releasing a torrent of reports, all at once, at 12 GMT. This hasn’t happened before and the associated markets are expected to react with a lot of volatility. I adjusted my rule for today. One loss and I’m done, and no trading after 10am. And guess what? I had a loss first thing! Yes, it happens. Now I haven’t had a loss in ten trades, so I was expecting it. However my internal chatter wanted me to keep trading, because I know from experience that two trades in a row is very unlikely. But the key is, I didn’t continue to trade. Because that internal chatter is not my friend, certainly not when trading. And discipline is more important that one losing trade.

I hope this was helpful.

Enjoy the rest of your week!

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