When you lose money on trades, you have what is known as a “drawdown.” As an example, suppose that your currency trading account begins with a balance of $100,000. You work your trading system, and after a bad trade, you see your account’s equity drop down to $95,000. Your account has experienced a $5,000 drawdown.
What You Can Learn From a Drawdown
Drawdowns also describe the likely survivability of your system over the long run. A large drawdown puts an investor in an untenable position. Consider this: A client who endures a 50% drawdown has a large task and a real challenge ahead of them because they must have a 100% return on their reduced capital stake to break even on the reduced equity position. Many investors or fund managers on Wall Street are ecstatic if they average 20% profit for the year. As you can imagine, when a trader suffers a drawdown, they are best served by implementing good risk-management procedures and readjusting their system instead of trying to trade their way back to the break-even point aggressively. Typically, a trader’s aggressive approach to get their capital back and break even will have the opposite result. Why? They will most likely become emotional, using leverage and over-trading to get their trading account back to where it was.
Too Much Leverage
Most traders use leverage to open trades because it can be very expensive to do so with cash. Problems arise when a trader uses excessive leverage. It makes it much harder to recoup losses and maintain your margin—not to mention you can lose your entire account within seconds. When traders use too much leverage, one bad trade can have disastrous effects—and it often does. After experiencing a loss, traders tend to become more aggressive and take too many risks. That usually leads to large losses or an unwillingness to accept a losing trade that they should cut.
Recommended Reading
What I Learned Losing a Million Dollars, by Jim Paul and Brendan Moynihan, offers some excellent insight if you’d like to read a book that describes the emotional toll of drawdowns. The book discusses how, by taking a large drawdown, a trader lost his career, significant amounts of his family’s fortune, and money belonging to his friends. The book also shares several tips on overcoming some common pitfalls in trading, such as implementing a trading plan that is likely to be emotionally driven instead of risk management-driven.
Final Thoughts
One of the most important and valuable tips you’ll hear is to set a stop-loss or stop-market order for every trade before entering. That will limit the amount of any drawdown you will take. Avoid making trading decisions based on emotion. Instead, focus on a strategy based on managing risk by exiting trades early enough to minimize your losses. Once you take these steps, you’ll be able to stand back after you’ve entered a trade, knowing that you’re out of it with no questions asked when and if your stop-loss level is hit. Many traders make the mistake of trying to stay in a losing trade, hoping for a change. This is a mistake because you’ll be making your trading decisions based on emotion instead of strategy. By staying in a losing position, you’re doing the least painful thing you can do. However, it’s not necessarily more beneficial down the road.
