Managing drawdowns is arguably the biggest challenge for traders

December 10, 2015, 12:11 pm ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

Managing drawdowns is arguably the biggest challenge for traders. 

Even the best Strategies, with great performance, have drawdowns, so as much as those are challenging they are also a necessary part of this business and any trader who means to achieve success in this business must encounter and overcome drawdowns not only occasionally, but probably regularly, every year, because they are a natural part of the business.

Managing drawdowns, however, can be difficult.  Of course it is best to start with a strategy that has a proven ability to recover from drawdowns, because then, when drawdowns do occur, history would suggest that the strategy would eventually recover.  New strategies do not have that tangible level of reference, so they're not quantifiable, but every strategy no matter how long its lifespan will encounter drawdowns.

One of the most popular ways of measuring a strategy's drawdown is to also measure the length of time it takes to recover after that draw down.  The recovery time is typically more important to investors because they want to know, if they do lose a little how long will it take to earn that back.

Other measures consider the profit potential along with the drawdown risk, and sometimes the profit potential offsets the risk of a drawdown enough to make the trade worth it, but be careful doing that.

Longevity matters:

 Investors are certainly more likely to stick with a strategy through a drawdown that has a 10 year track record versus one that has a 2 year track record, and that's important because that is usually the difference between being successful and walking away losing a little.

The difference usually boils down to sticking to it.

I have been offering proactive trading strategies online longer than anyone I know, we started in January, 2000, which was the onset of online trading reliability, I have seen quite a bit, but one thing that rarely changes is the inability of most people to 'stick to it.' 

People cite many different reasons for not following through, some make mistakes, some just don't have the time, but whatever the reason people tend to make the majority of their mistakes during drawdowns, they stop being disciplined, they stop following strategy if they are DIY investors too, and that means they stop 'sticking to it.'

It's essential, as a result, that we not make stupid human mistakes during drawdowns.

Instead, we need to adhere to disciplines, and avoid all temptations to diverge.  Any divergence in strategy completely changes the strategy, and therefore could distort the strategy's ability to recover from drawdowns.  Some changes can be positive, some negative, but both are different than the strategy, so making a change like that during a drawdown is not advised.

Let's not be arrogant:

Look, some strategies are better indicators than they are manageable by normal investors, who have a job or some other responsibility that prevents them from trading in lock step with the strategy, so normal investors can use the positioning of strategies (long, short or cash) to help them gauge other unique decisions they may be making with their personal portfolios. 

Other investors will modify a strategy slightly to fit their needs, but so long as that rule is adhered to as well a change like that would be perfectly fine.  Most Strategies are not perfect, and some are used as building blocks for personally defined strategies.

For example, assume a Swing Trader says: I will follow the Swing Trading Strategy, but only on Wednesday, Thursday, and Friday.  That would change the strategy completely, the results would be different, but that would be fine so long as that rule was always followed.  In this example, the probability of a little better or a little worse than the strategy would be close to even.

My suggestion is to STICK TO IT

If you have modified strategies in place, or you are following s strategy in lock step, it is important that you wrap your head around a drawdown before it happens, and you should have an idea of what the recovery time should be so you can quantify the period in advance.  That will help you make it through a drawdown, which usually looks ahead to profitability in that strategy.

In conclusion, there's nothing wrong with slight modifications, even though I don't think they're needed, and remember that you will be essentially starting a new strategy with no track record when you do that, but I have a huge problem with making fast decisions and changes during a drawdown because that is when the most irrational decisions are made. 

• Do not make material decisions to strategy development during drawdowns.
• However, getting started with a strategy during a drawdown could be a great idea.

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