Why is drawdown in trading important? Why should you spend time thinking about what is a good max drawdown percentage? How you prepare and deal with drawdowns in trading is important. Why is it important? Because a drawdown makes you fiddle, change, abandon your strategies, or stop trading altogether. Thus, a good trading plan deals with drawdowns before they inevitably happen. Our anecdotal experience indicates most traders and investors (including ourselves) underestimate their risk tolerance. What looks tolerable in backtesting is not as straightforward when dealing with real money and real losses.
A good max drawdown is less than 25%. To handle, reduce, and decrease inevitable drawdowns, we suggest trading small, trading many markets and time frames, but above all, make sure you trade within a wide margin of risk tolerance. To minimize drawdowns, you need to be prepared!
Max drawdown is important in trading because it influences your behavior and, obviously, your returns. Both are dependent on each other. What is a good or acceptable drawdown percentage? There is no definite answer, but preferable to be as low as possible. If it gets too big, more than 25%, many traders lose hope and stop trading. Thus, 25% can serve as a heuristic for max drawdown. Most traders believe they can handle bigger drawdowns, but we believe they overestimate their pain tolerance.
In this article, we look at why you should focus just as much on drawdowns as profitability.
What is drawdown in trading?
A drawdown in trading is the percentage you are down from the latest equity peak. It’s a peak-to-trough decline over a certain period. You are in a drawdown if your equity is not at an all-time high. Thus, most of the time, you’ll be in a drawdown!
Most of the time, the drawdown is minuscule and nothing to worry about. Still, when it reaches double percentage digits, the drawdown can significantly affect your future returns because of our trading biases. We discuss why in this article.
Drawdowns are best explained with an example:
How do you calculate a drawdown? (How to calculate)
Let’s assume your equity today is at a record 95 000, but over the next two months, it drops to 85 000. Your equity drops 10 000 in nominal value. Hence, the 10 000 is your drawdown.
Drawdowns are better valued in percentages. A 10 000 drawdown is 10.5% of the peak of 95 000.
Thus, the drawdown is 10.5%.
The drawdown ends when your equity sets a new peak above 95 000, and the process starts again.
Graphical examples of drawdowns
Below is a graphical example of a drawdown in the ETF QQQ:
The first pane is the price of QQQ, while the red color in the pane below shows the percentage drawdown from the latest peak in QQQ.
The drawdown above shows, for example, that the QQQ set a new high in late February 2020 before it fell to a drawdown of 27% in March. However, it quickly set a new high again in June.
Drawdowns can be lengthy. The drawdown of 27% in March 2020 is almost a drop in the bucket compared to what happened after the dot-com bubble burst in 2000:
The drawdown didn’t end until 2015! 15 years is a pretty long time to wait for a drawdown to recover. The max drawdown during this period was a hefty 83% in late 2002. This means 100 000 invested at the peak, was only worth 17 000 two years later. You need a strong character to not lose hope after such a disastrous performance. We are confident those investors and traders give up and lose interest. Such a poor performance would gut most traders and investors.
Two types of drawdowns: closed and open
We have two types of drawdowns: closed and open:
A closed drawdown is a drawdown measured from the closing price to the next closing price, while an open drawdown include the intraday drawdown between the closing prices.
These two types might differ, primarily if you use leverage. Nassim Nicholas Taleb writes that “you shouldn’t cross a river that is on average four feet deep”.
Likewise, the close-to-close drawdown might fool you into unrealistic expectations when an intraday drawdown might force a margin call. Taleb is spot on in his analogy.
Why Is Max Drawdown Important In Trading?
- During a drawdown, you ask yourself: Has the system stopped working? You hesitate and stop trading.
- Is this the beginning of a larger drawdown? You are unsure and stop trading.
- Am I doing something wrong? You pause the strategy and alter the variables before resuming (with a new strategy).
These three simple reasons should always be in the back of your mind in the development process. What is your risk tolerance for drawdowns in trading? Drawdowns increase the risk of behavioral mistakes. Will you still have faith in the system after a losing streak? The answer might not be evident when real money is at stake because you never know if the drawdown is temporary or permanent.
Drawdown is very important for a trader because they significantly impact your compounding abilities. Huge drawdowns might force you to stop trading; it might even lead to ruin and lower your returns.
Opposite, low drawdowns can make leverage useful and make your trading scalable.
Below we have listed the main issues of why you should focus on drawdowns, preferably before they happen:
Low drawdowns limit behavioral mistakes
All things equal, a trading strategy with the least drawdown is preferable. Why is that?
The reason is simple: a ton of research shows that humans are prone to commit behavioral mistakes when we are under pressure. Behavioral mistakes can be labeled cognitive mistakes that we do over and over and are a failure to think clearly, which systematically deviate from logic.
Most of us have problems detaching from money, and we let money and emotions overrule our trading signals. We jump ship amid a drawdown and let our trading strategies sail their way.
Interestingly, we don’t jump ship when money keeps rolling in. During smooth sailing, no one thinks about losses and the subsequent drawdown.
Almost everyone is risk-averse, for example, meaning we react more negatively to losses than to similar gains.
This is an obvious example of loss aversion:
If you make 100 000 per year in ten years, you will feel pretty good in all ten years. Opposite, if you make one million in year one and nothing in the next nine years, you have one excellent year and nine miserable years. You would likely be much happier by making a lot less but steady gains every year.
Drawdown is much the same: we prefer a “sure” income with little volatility over a higher income but with much more volatility. Likewise, most traders are willing to “gamble” to avoid a loss, but react opposite when facing a potential gain.
To better understand your behavior and cognitive errors, we recommend two books:
Rolf Dobelli has written The Art Of Thinking Clearly. He describes the most common 99 mistakes we make over and over again. The book is an easy read and sometimes quite amusing.
The other book we recommend is Daniel Kahneman’s Thinking, Fast And Slow. This is a bit heavier, but Kahneman is a pioneer in behavioral finance.
How much drawdown can you handle before you give up?
Drawdowns make you, as mentioned, jump ship. Many take a breather and pause their strategies after taking some beating in the markets, only to resume when they see the strategy has recovered.
This is flawed in the long term. It makes you go around in circles. This is why private investors do poorly in the stock market: buy the tops, and sell the bottoms.
The problem is you never know when the strategy has stopped working or if it’s just a normal cyclical downturn.
To minimize this mistake, always start by understanding your trading strategy. If you do no understand why the strategy should work, you obviously have no knowledge of when it stops working. Ensure you understand the edge and have done backtests over long periods.
The length of drawdowns is important
An overlooked issue of drawdowns is the length of it. As described above, the extent is measured in percentage, but the length is measured in days, weeks, or months.
You might not suffer an extensive drawdown in percentage, but as months go by without winning, the daily grind gradually withers your confidence. You might give up – precisely when things turn around for the better.
Some strategies have a high win ratio with many small winners and occasionally big losers. Mean revertive strategies fit this description.
Opposite, some trend-following systems have a low win ratio, with many losing trades but a few big winners. Trading often involves alternatives, and you need to evaluate how you deal with such issues and how to overcome them.
Drawdowns result in lower CAGR and compounding
The 83% drawdown in Nasdaq between 2000 and 2002 would need a 590% return to recover to the peak. That would take 12 years with a 15% return, 18 years with a 10% return, and 25 years with 7%. A 50% drawdown requires a 100% return to get back to even. A 75% drawdown means you need to grow your remaining capital 400% to get back to former glory.
These simple numbers explain pretty well why it makes sense to have low drawdowns.
The lower drawdown you have, the higher level you can start compounding from:
A low drawdown equals compounding from a higher level
You don’t need to be a genius to understand that it’s better to start compounding with a capital base of 100 000 instead of 50 000. Given equal returns, you make more money the more capital you have.
You have to look at drawdown the same way. After each drawdown, you start compounding at a higher level.
The graph below illustrates this pretty well:
The graph has two lines: the black line shows the buy and hold of the S&P 500 (SPY) from 1993 until July 2021 (log scale), while the red line is a trading strategy part of our monthly Trading Edges. The dates are not included in the chart, but from 2000 until 2010, the S&P 500 had negative real returns while the strategy continued to perform well.
What is the main takeaway from the graph above? To minimize drawdown is important. When a trading strategy keeps you out of trouble, you can start compounding at a higher level/base.
Because the strategy keeps you out of trouble, i.e. it has less drawdown than buy and hold, you can start compounding at a higher level when the dust settles. This is the main advantage of trading vs investing, in our opinion. After the GFC in 2008/09, the strategy started at a higher level because it hardly had any drawdowns during the crisis.
For the most part of the period from 1993 to 2021, the strategy has significantly less drawdown than the buy and hold, but at the same time, it seems to keep up when the S&P 500 starts rising. This is the main reason why this strategy outperforms the buy and hold. Please keep in mind that the strategy above is only invested about one-third of the time, and we can argue the risk-adjusted returns are significantly higher than the nominal returns.
The best example of drawdown and compounding happened during the Covid-19 mess in March 2020. The strategy hardly had a drawdown, but it “exploded” on the upside when the S&P 500 also bottomed. The strategy did an excellent job of preserving your capital while making you invest at the bottom. When the dust settled, you started compounding from a higher base. The strategy preserved your capital during turbulent times.
Drawdowns can lead to ruin
To avoid ruin should be in the back of the head of any trader at all times. If your trading strategies have big drawdowns, this increases the risk of ruin if they all turn sour simultaneously.
Nassim Nicholas Taleb had a fantastic saying in one of his books:
Never cross a river that is on average four feet deep.
This applies to trading as well. If you take on a strategy with the potential for huge drawdowns, you should be careful in implementing it. It might drown you.
Low drawdowns can take advantage of leverage
When you are trading, you are looking to exploit short-term trading edges. You can sometimes afford to use leverage because you spend much less time in the market than buying and holding and subsequently experience lower drawdowns.
Leverage mostly comes in two forms:
Futures trading is always based on margin because it’s a “bet” between two parties and only requires a deposit normally not higher than 10% of the value of the contract:
If you are trading ETFs, most brokers offer you margin, limited to the size of your equity (2x equity in leverage). You’ll need to pay interest on the margin.
We are not recommending leverage even though we use leverage via futures and moderate doses of margin from our brokers. Leverage always involves risk because it backfires if you get it wrong. You have to be very careful and deeply understand what you are doing.
Drawdowns affect scalability
Short-term trading is much more scalable than long-term investing. If you’re good, you can get rich in a hurry, but very few succeed. We recommend to not getting rich in a hurry.
Opposite, long-term buy and hold requires a ton of patience, and the snowball doesn’t accumulate until 20 years have passed.
Please read more about trading vs. investing on these two links:
Drawdowns are inevitable
We will get hit from time to time with large losses. Charlie and I, however, are quite willing to accept relatively volatile results in exchange for better long-term earnings than we would otherwise have had. Since most managers opt for smoothness, we are left with a competitive advantage that we try to maximize. In other words, we prefer the lumpy 15% to a smooth 12%.
The quote above was made by Warren Buffett, a man who needs no introduction. Buffett’s comment is important. Buffet’s partner, Charlie Munger, said this:
If you can’t stomach 50% declines in your investment, you will get the mediocre returns you deserve.
The share price of Berkshire Hathaway has declined more than 50% at least three times: Once during the inflationary period in the 1970s, once from 1998 to early 2000, and the last time in 2008. Furthermore, Berkshire has underperformed the S&P 500 for at least the previous six years from 2015 until 2021. Yet again, in 2020/21, Warren Buffett has seemingly lost his magic touch.
Despite this, Buffett and Charlie Munger have managed almost 20% annual returns. At intervals of 5-8 years, Berkshire has suffered significant setbacks in the share price without the duo losing their self-confidence and faith in their investment philosophy.
When you start trading your first focus should be to understand your risk tolerance. That is, of course, very difficult when you are a beginner. We all start as optimists and count our chips before our first trades!
Many start trading instead of investing long-term because they can’t stomach huge drawdowns. A trader can, if he or she is good, minimize drawdowns. However, it’s not easy and requires work. A low drawdown strategy is the goal, or perhaps even better, a portfolio that could cancel out single strategy drawdowns.
It’s important because many traders try to smooth strategies and end up curve-fitting instead. Unless you have a fundamental structural edge, you must accept that drawdown is the price you pay to get good market returns.
You can reduce drawdowns via diversification (see more below), but you can’t avoid drawdowns totally.
Drawdown in trading is inevitable, and you must accept that as a fact of life.
Furthermore, your biggest drawdown is most likely yet to come. How will you react after a big loss?
Drawdown in Trading vs. drawdown in investing
To avoid drawdowns, many switch from long-term investing to short-term systematic trading.
Even though Buffett has managed almost 20% a year, the price he pays is an enormous drawdown at odd intervals, as we wrote above. That’s why you are a trader and not a long-term investor! Surely you can minimize drawdown by short-term trading and market timing?
Unfortunately, no matter your time frame, you can’t eliminate risk. Even The Medallion Fund, the world’s best-performing fund, was on the brink of collapse in 2007 despite its steady gains and high Sharpe Ratio. Don’t fool yourself into believing the financial markets offer you easy money. They don’t, and you’ll get kicked in the teeth when you least expect it.
Drawdowns and the Sharpe ratio – the least amount of pain for the same return
Drawdowns are an essential tool for comparing strategies and performance. The chart below shows the performance of Brummer & Partner’s return since 2002 (red line) and the MSCI World Index (grey line). Both have almost the same CAGR, but Brummer’s returns have been smooth with minor variations:
Which investment would you choose – Brummer or MSCI? It’s safe to say the great majority would choose the red line (Brummer’s return). The reason is simple: it offers the least amount of pain going from A to B.
Given two alternatives with the same CAGR, most traders and investors chose the one with the smoothest returns, ie. the one with the minor drawdowns and variations in the return. However, this doesn’t mean you shouldn’t include strategies with significant drawdowns. The reason why Brummer has managed smooth returns boils down to trading many markets and time frames. You should do the same.
A mathematical way of measuring the quality of the return is the Sharpe ratio. A high Sharpe ratio is preferable to a lower one. However, many funds “blow up” despite many years, even decades, of low volatility and high Sharpe ratios, so be careful.
Why you need to accept drawdowns as part of cost of doing business
Looking at the 15-year records of all the actively managed U.S. domestic equity funds that existed at the start of 1998, we find that not only are long-term outperformers rare, accounting for only 18% of those funds, but they also experience numerous and often extended periods of underperformance. Indeed, nearly every one of the successful funds underperformed in at least five of the 15 years through December 2012. Furthermore, two-thirds of them experienced at least three consecutive years of underperformance during that span. We conclude from this analysis that investors pursuing outperformance not only have to identify winning managers, but historically have had to be very patient with those managers to collect on their success.
To be a long-term winner, you can’t always be a short-term winner.
Despite the psychological damage related to severe drawdowns, you may seek comfort in the fact that drawdowns are inevitable. Trading is difficult because we prefer steady gains, but the market offers only random lump-sum rewards. It would help to look at ways to reduce and decrease your drawdown.
On Twitter, you might look at other traders who seemingly never have a losing trade. But don’t fool yourself!
Setbacks are part of life. How you deal with setbacks eventually determines if you end up ahead or quit at a trough in your equity curve.
It’s logical: if you want smooth, risk-free returns, you get returns close to zero. Anything above that involves risk, and the risk comes in the form of drawdowns. No one likes to lose, but you can’t always expect to win. You have to endure short-term pain to get long-term gain.
Don’t avoid drawdowns in trading- accept them and use them to your advantage
Many traders manipulate strategies by adding variables or setting unrealistic parameters. The result is a curve-fitted backtest.
However, drawdowns are inevitable. Don’t ignore a strategy just because of its drawdowns. Some strategies work because many abandon ship at the bottom of the cycle. Use that to your advantage by accepting and managing drawdowns.
As a rule of thumb, the more frequent drawdowns in a strategy, the more likely it’s to stand the test of time. A strategy with small or insignificant drawdowns is more likely a result of chance, randomness, or curve fitting.
Most strategies stop working sooner or later
Nothing lasts forever, and certainly not in the financial markets. Markets change and evolve. It’s natural that edges disappear and grind to an end. Very rarely does a strategy “blow-off”. If you know why a strategy works, you stand a better chance of knowing when it stops working.
How to reduce drawdowns in trading
No matter how prepared you are, a drawdown makes even the most confident traders unsure and nervous. You should aim for small drawdowns to avoid behavioral mistakes, but not by turning good strategies into perfect ones. Think holistically when it comes to drawdowns.
Below we bring forward some arguments we believe you should keep in mind before you start trading so you are better prepared for the inevitable trading drawdowns:
Align your trading style with your personality
It helps if you trade with conviction and self-confidence.
For example, so-called trend-following strategies in the commodity markets have always required huge drawdowns and many years of underperformance to reap historically high returns. Are you able to execute your strategy after ten losers in a row? Are you able to stick to the strategy after two losing years in a row? Most traders can’t.
No backtest prepares you for setbacks that make you stop or alter your strategies – at the exact wrong moment. How many percentage points of drawdowns can you tolerate? 10%? 30%? 40%? Only trade strategies you are confident to follow.
You don’t get successful by copying the trading style of someone else. Noise and random movements ensure you quit at the worst moment if you have not spent time dealing with the systems independently.
Reduce and decrease trading drawdowns by trading many strategies
Never rely on just one strategy – make sure you have many strategies. Don’t try to make low drawdown strategies, but focus on making a good portfolio of trading strategies. The best way to reduce drawdown is to diversify:
Trade many markets – low correlation reduces trading drawdowns
There is no help in trading many strategies if they are all pretty similar in length, type, and market. Correlation in trading between asset classes increases when volatility picks up, but some markets might go in opposite directions, like bonds and gold. Trading different asset classes is an excellent tool to reduce drawdowns.
Short selling is difficult, but they might offer uncorrelated returns even though their total returns might not be so attractive.
Trade different time frames
Even during an extended bear market, you can make money on the long side via day trades, often uncorrelated with the market’s overall trend. Different time frames in trading are an excellent tool in creating uncorrelated strategies.
Trade small sizes and stay well within your comfort zone
The best way to reduce drawdown is by trading small. Always trade smaller than you’d like and within a wide margin of safety of your comfort. Too many traders get greedy and trade too big, which often backfires.
For example, assume your strategy has historically had a drawdown of 40%, which is way too big for most traders to handle, no matter how high the annual returns are. Instead of ignoring the strategy, trade small and allocate less capital than you otherwise would do.
The beauty of automated trading is the ability to trade an almost infinite number of strategies. Use that to your advantage!
When you add a strategy to your portfolio, make sure it adds diversification and is uncorrelated with the other strategies
Simulate how your portfolio of strategies has performed before you go live with it.
A good stand-alone strategy doesn’t necessarily add much value to an overall portfolio because of overlapping trades. Opposite, a mediocre strategy might add more value to the portfolio because of diversification. Don’t look for the holy grail, a portfolio of sub-optimal strategies might perform very well together.
How to avoid drawdowns – summary
Diversifying into different asset classes, time frames, and strategies is the best way to smooth drawdowns. You want to trade many different asset classes, different types of strategies (mean reversion vs. trend following), different market directions (long and short), and different time frames (short-term trading vs. long-term investing).
We have covered this in numerous articles before, and we recommend reading the strategies below at the end of this article.
The biggest trading drawdown is yet to come
Always assume that the drawdown in live trading turns out to be bigger than your backtest indicates. No matter how simple your strategies are, every backtest involves some curve-fitting. Always assume the “worst”.
The biggest drawdown is yet to come.
Drawdown in a historical perspective – 180 years of stock market drawdowns
Let’s look at drawdowns in the stock market. We look at stock market data for over 180 years to do this.
In a presentation to the Institut des Hautes Études Scientifiques (IHÉS), termed An Analysis of 180 Years of Market Drawdowns, which is available on YouTube, Dr. Robert J. Frey, a former hedge fund manager and quant trader (whose firm was actually bought out in the 90s by the legendary hedge fund manager Jim Simons), discusses market drawdowns and uses different models to show that they have been the same over the years. How often do we witness drawdowns, and how long do they last?
For any given trading period, prices inevitably show peaks and valleys. There have been several market drawdowns over the last 180 years, and it seems drawdowns are the most constant factor in the market.
Let’s take a look at the key points of Dr. Frey’s analysis, but first, let’s define market drawdowns.
What are stock market drawdowns?
As you know, the market shows peaks and valleys for any given trading period. A drawdown is simply the total change in price from one market peak to the next market valley. It is a peak-to-trough decline during a given trading session, which can be daily, weekly, or monthly, and it is usually quoted as the percentage of the market peak. On the monthly timeframe, the drawdown can be from less than 5% to more than 20%. That is, in a month, there can be more than a 20% drawdown.
When the price of a security falls below the highest and then rises again during that trading timeframe, a drawdown is recorded. As expected, the longer the price of a security stays below the last peak, the more the possibility of a lower trough, thus increasing the amount of drawdown. To establish that a drawdown is over, the price has to again crosses the highest peak earlier witnessed.
Having a good knowledge of drawdown is crucial to managing market turbulence, gauging volatility, and measuring the inherent risk associated with a security and an investor’s potential losses. Drawdowns represent the largest loss an investor can potentially experience during that trading timeframe. But it is different from an actual loss, which is computed as the difference between the purchase price and that at which an asset is bought or sold in the market.
Looking at drawdowns over a period of 180 years
In the words of Dr. Frey, “We tend to be inadequate historians.” Market drawdowns are more common than we think, and they seem to be fairly consistent over the years. In fact, while the usually logarithmic charts of the US stock market tend to show sustained growth over the years, drawdowns are the most consistent thing in the market.
According to Frey, risks (specifically, drawdowns and losses) are one constant in the market going back all the way to the early 1800s. He presented a couple of different charts on the market and used different statistical models, such as linear regression and Lomax distribution to make his point.
First, here’s the long-term growth of the US stock market (drawdowns are shaded in red and logarithmic chart):
When he pulled out and looked at the drawdowns, he could see the drawdowns everywhere and of different sizes, as you can see in the chart below.
In his words, “You’re usually in a drawdown state.” It could be a 5%, 10%, or 20% drawdown, and the duration can vary — from a month to many years, as in the crash during the Great Depression. From the chart above, you can see how consistent losses have been over each and every decade or economic environment. Drawdowns are really the one constant across all cycles.
With a linear regression model, Dr. Frey could demonstrate that the size of the drawdowns is proportional to the duration of the drawdowns.
But while the duration of the drawdowns varies, there have not been fewer drawdowns in recent years, despite all the changes introduced into the market over the years.
Changes that have taken place over the last 180 years
Many regulatory changes have been made in the US stock market since the 1800s, as Dr. Frey points out. Some of them include the creation of the Fed, monetary policy, fiscal policy, the end of the gold standard, tax rates, valuations, the industry make-up of the markets, and a number of other things, such as the introduction of circuit breakers to curtail flash crashes.
But in spite of all these changes, there have been no significant changes in the frequency of drawdowns over the 180 years period.
As Frey pointed out, drawdowns are one constant thing in the market over the years. According to him, investors at any point in time are at a 75% chance of being in a drawdown state. In other words, one spends about 75% in a drawdown, and what is mindboggling is that more than half of that time is spent in a major drawdown, which he defined as a more than 20% drawdown.
Since stocks don’t make new highs every single day or even month, most of the time, an investor is underwater and in a state of regret when investing in stocks. This shows the importance of emotional control and developing the right psychology when investing in stocks.
It’s easier to predict risk than returns
Experience has shown that it is practically impossible to predict what the future returns will be in the stock market — no one knows what the future holds for economic growth, and neither can anyone predict how investors will decide to key economic and market indices at any point in the future.
But if there is one thing we can predict about the market, it is the risk — the markets will continue to fluctuate, giving rise to drawdowns. In other words, we are almost certain that there will be drawdowns on a regular basis.
Preparing the mind for inevitable drawdowns
As an investor in the stock market, your portfolio will be underwater most of the time, so you are likely to spend a lot of time second-guessing yourself about your trading decisions — should’ve closed the trade, shouldn’t have bought at this time, and similar mental battles.
To succeed in the stock market, you must develop the mental muscle to handle drawdowns!
Drawdowns are inevitable
Because they are inevitable, you need to be prepared. If you are a long-term investor, you get the chance to buy at lower prices (which normally is a gift). If you are a short-term trader, both long and short tend to perform better. Please read our article about stock market crash strategy.
How Much Pain Can You Take? Risk, Hindsight, Consistency And Paper Trading
Let’s end the article with some personal anecdotes we wrote as far back as 2013. It was initially written as a separate article, but we believe it serves a purpose in this article about drawdowns. It’s written in the “I”form.
The risk is real, and trading is not easy.
The above quote is from page 110 of Curtis Faith’s The Way of The Turtle. A great book! This sentence captures the essence of trading: a very difficult endeavor that ultimately leaves your inner strength exposed.
It all looks so easy when looking at backtested equity curves. Just follow the rules and rake in the money. Yes, sometimes there is a drawdown, but the graph shows an upward slope immediately after. Looking at it from an ecological perspective, drawdowns are like prey – necessary and natural to eliminate the weak players.
Trading is about managing drawdowns
However, most people learn the hard way (including me) and realize it is not so easy after all. A strategy might yield 10% per year, but you experience nasty drawdowns along the way.
Can you handle a severe drawdown? Do you know where your psychological limits are? How much pain can you take before you abandon the strategy? Is 30% an acceptable drawdown?
When looking at many years of equity curves (and not logarithmic ones), a 30% drawdown looks so tiny on a chart. But in real trading when real money is at stake, such a drawdown is not small anymore. Do you continue trading? Do you stop?
I feel pretty confident when I say that most people would quit. This is especially true if you trade only one system/strategy. So in order to succeed in the long term, you have to understand how drawdowns can change your decision-making process.
Behavioral mistakes compound
Peter Lynch had an incredibly good track record for a long time when he managed his fund. But to his astonishment, the vast majority of his investors were not even close to obtaining his numbers. Quite a few actually made a loss. Why?
Because they buy the fund after it has risen, and sell after it has fallen. They do the complete opposite of what you should do. They buy high and sell low – knee-jerk reactions and emotions.
Therefore, it’s important to develop a strategy that you can follow. And I believe a system with less drawdowns is much easier to follow. That does not necessarily mean lower returns for the long term as long as you follow the strategy (vs. theoretically better returns with bigger drawdowns – but less likely to follow).
Some trading strategies are hard to follow. Drawdowns once in a while are many percent. One day I was long and holding GDX overnight, but GDX was down 2.5% at the open. According to the strategy, I should reverse the position and go short. Every inch of my contrarian body resisted going short. Luckily I followed my trading rules and GDX fell a whopping 3% from open to close so I managed to recover my overnight loss. It’s so important to follow the rules! And just as important to have many strategies. The GDX strategy is just one of many I currently have.
Trading is about preserving your capital
Your goal in trading is to make money, but you have to preserve capital to make sure you can make money.
It sounds like a contradiction, but it isn’t. You have to remember that time is on your side. If you have a positive expectancy you’ll make a lot of money. But to make money you have to take risk, and that form can either make you:
- Stop trading after a drawdown (which will happen sooner or later), or you can
- Have a spectacular loss and lose much of your capital.
Know your risk tolerance
That’s why you have to become familiar with your risk tolerance before you start developing systems and strategies. And when you start trading, start small until you have some years of experience.
Risk management is a trade-off between risk and reward. You have to find the balance between losing too much or leave too much on the table. You can never know in advance how much heat you can absorb until you start trading. Everything looks so easy using hindsight. But when you’re in the middle of a severe drawdown you never know if the strategy has stopped working or if you’re in the middle of a “normal” drawdown. Thus, always have a margin of safety.
Think about this: if you lose 10% of your capital, you have to make 11.11% to get even. If you lose 30%, you have to make 42.85%. By 50% you have to make 100% to get back!
Also worth noting: The longer you trade, the bigger the drawdowns. It’s easy to find a strategy backtested just a couple of years that has minimal drawdowns. A longer history will capture different markets for a strategy. You also have to take into consideration the frequency of your trading. The law of big numbers can be used to your advantage.
Consistency and drawdowns
One of the most important factors to succeed in any trading endeavor is to be consistent. Of course, when you have a big edge, you can trade bigger. But in order to build confidence in your trading, you have to be consistent.
When you have become consistent over a long period, you can increase size and trade more aggressively. If you’re not consistent, how can you determine if you’re lucky or really good (if you make money)?
There is an enormous element of randomness in the markets, and there will always be a lot of traders making money simply by chance. You might have found a strategy that makes money, but that strategy only works in a specific market. When the market change, you start losing money.
Curtis Faith writes this:
The most important lessons in life are simple yet difficult to execute. In trading, concistency is the key. A systematic trading approach, a through understanding of the limitations of that approach, and the tools used to build trading systems can help you be more successful and constant. You must be consistent to trade well. You must be able to execute your plan or the plan has no meaning.
We let Mark Minervi get the final words in this article (page 175):
I think paper trading is the worst thing you can do. If you’re a beginner, trade with an amount of money that is small enough so that you can afford to lose it, but large enough so that you will feel the pain if you do. Otherwise, you are fooling yourself. I have news for you: If you go from paper trading to real trading, you’re going to make totally different decisions because you’re not used to being subjected to the emotional pressure. Nothing is the same. It’s like shadowboxing and then getting in the ring with a professional boxer. What do you think is going to happen? You’re going to crawl up into a turtle position and get the crap beat out of you because you’re not used to really getting hit. The most important thing to becoming a good trader is to trade.
Conclusion: Why is max drawdown important in trading?
Drawdowns in trading are inevitable. No pain, no gain.
Look at drawdowns as the cost of doing business and use them to your advantage by trading smaller than you normally would do. Don’t throw away strategies with huge drawdowns – they might offer value in the form of correlation and diversification. Make sure you trade many markets and time frames. Diversification is the best way to deal with drawdowns in trading. Diversification is the best tool to reduce drawdown.
Max drawdown in trading is essential because it plays a major role in how you compound long-term. A drawdown can make you jump ship or make a real dent in your performance. How you react to a drawdown is important; thus, ensure you understand why your trading strategies work.
A good drawdown percentage is as little as possible. Many traders stop trading when the drawdown reaches 20-25%, so you need to spare some thought on how you would react if you experience such a drawdown.
Always ask yourself: how will you react if you lose 25% of your equity? This is why drawdown in trading is important.
– How can a good trading plan help deal with drawdowns?
A good trading plan anticipates drawdowns before they happen and includes strategies to handle, reduce, and decrease them. It emphasizes trading small, diversifying across many markets and time frames, and ensuring trading occurs within a wide margin of risk tolerance.
– Why do traders often underestimate their risk tolerance?
Traders, including beginners, tend to underestimate their risk tolerance because what appears tolerable in backtesting may become challenging when real money and real losses are involved.
– How can traders prepare for inevitable drawdowns in trading?
To prepare for drawdowns, traders should focus on understanding their risk tolerance, trade small, diversify across multiple markets and time frames, and ensure they are well within their comfort zone in terms of risk.