Investment Trading Risk Management
Drawdowns and Required Percentage Gains
Do you really understand how important managing your trading risk is?
Going through drawdowns isn’t only something that a trader has to manage emotionally and psychologically, it impacts your overall trading results. How?
Trading Risk Management: Drawdowns and Required Returns
Let’s take a look at how drawdowns can impact your overall trading performance.
To simplify the implications, take a look at the following numbers:
Table of Drawdowns and Required ROI
What do those numbers mean?
- For a drawdown of 10%, you will require 11.11% to make up that loss.
- For a drawdown of 20%, you will require 25% to make up for that loss.
- For a drawdown of 30%, you will require 42.86% to make the loss.
When your account hits a drawdown of 50%, you will need to grow it by 100% in order to break even from where you started.
Investment Risk Management: Putting Drawdowns into Real Trading Perspective
Looking at theoretical numbers sometimes causes the real impact to be lost on the trader. To understand the impact of drawdowns better, let’s meet Trader A.
The Example of Trader A:
Trader A has been learning how to trade for some time, and just started trading a real money account. He has a fairly decent trading system, and has been on a winning streak as of late.
Consistently making 5% a week over 8 weeks, Trader A manages to grow his account from $10,000 to $14,774.55. It took Trader A time, energy, discipline and risking his money to grow his account by 47% over 8 weeks, an incredible return by any means.
Trader A is elated, supremely confident and on a roll. Trading is easy and effortless, and he’s thinking about how rich he’ll be in 2 – 3 years time, especially if he continues making money the way he is. He’s in the zone, and feels untouchable!
Suddenly, he makes a first loss. But it’s OK, he tell himself. Taking a hit now and then is part of trading. But he’s still confident of his ability to trade in the zone, so he doubles up on his next position, hoping to make it back in one trade.
Alright! He hits the trade, and he’s back to new equity highs.
On the following trade, he takes a loss again. He think it’s still OK, just double up on his position risk because he knows he’s going to make it all back on that next trade. After all, he just did that, didn’t he?
But this time, he didn’t, and now he’s in a deeper hole than before. He decides to double up one more time, and again he loses. Now he’s starting to go deeper in the drawdown, and he’s starting to panic. His dreams of making millions starts to waver and fade like a mirage in the desert.
Trader A starts taking more trades, hoping that he can make it all back by the end of the week. But alas, he ends the week at $7,387.28. He’s down 50% from his equity highs.
Getting Back To Equity Highs
It took Trader A 8 weeks to grow his account from $10,000 to $14,744.55.
In less than one week, his account dropped to $7,387.28. In order for him to make it back to $14,744.55, it’ll take him 14 weeks making 5% a week consistently to get back.
And that’s if he’s able to consistently make 5% a week for 14 weeks running.
Is it any wonder why the lack of respect for risk causes so many traders to lose in the forex markets?
Respecting Your Trading Risk
While that’s just an example, it’s to illustrate why as a trader you always have to respect risk.
It’s not only about the number crunching, and how many percentage points it requires to grow your account. It’s also about the time and energy required to do so.
Handling drawdowns emotionally and psychological can already be tough enough on new traders. But without a healthy respect for risk, traders can put themselves into a whole lot of trouble before they even realize it!
Trading risk is like fire. You need fire to keep yourself warm, to cook food and many other practical and productive uses. Yet, when there is a lack of respect for what fire can do when left to run unchecked, fire can completely destroy almost any and everything in its path.
Left unmanaged and unchecked, trading risks take out new traders faster and harder than almost anything else. Even having a lousy trading system with a healthy respect for risk buys time for the trader to realize what’s happening and take corrective actions.
So when you trade, make sure you not only have a solid, robust and compatible trading strategy, but a good money management plan and a healthy respect for risk.