Understanding Drawdowns

Well, we certainly got off to a flying start with the new blog. In this first week we have had nearly 3000 ‘hits’ and there were a healthy number of juicy comments and questions – I thank you all for being so open and active in your postings to the blog. This is exactly how I envisaged this blog would begin to work – as an open and transparent way for you all to have an active role in sharing information, experiences, questions, and your thoughts.

A recurring theme from last week was the fact that those of you that are actively trading are experiencing an equity drawdown of varying degrees, so I thought a few comments on understanding drawdowns may be appropriate.

Trading systems will always experience equity drawdowns. No system, regardless of the market in which it operates can continue to show ever-increasing equity, without experiencing drawdown or profit give-back at some stage. A Portfolio can potentially spend up to 75% of its life in drawdown. It is the severity of the drawdown, and how it is managed that is the most important factor of any trading system. When a portfolio is not in drawdown it is making a new equity peak, which when you think about the All Ordinaries Index, or any index, stock, or commodity for that matter, doesn’t happen that often.

Futures market traders are, by nature of the markets in which they trade, much more aligned to an acceptance of equity drawdowns than the majority of equity traders. This arises for 3 main reasons. Firstly, futures positions are not normally considered to be long-term ‘buy and hold’ type investments. Secondly, futures markets tend, on average, to experience trends that are much shorter in length than trends in equity markets. It could be argued for example, that the recent bull market for equities has lasted for anywhere from 3 to 5 years. It is rare to see these excessively long-term trends in the majority of futures markets. Thirdly, far more futures traders trade with mechanical systems than equity traders. Mechanical traders expect drawdown as a natural part of their trading because they accept it as a part of their edge.

So, futures traders expect that systems will go into drawdown as a result of the system being out of sync with the direction of the market for periods of time. Overall though, if the system is solid, and has well-researched entry and exit rules and strict money management rules that provide an edge, it will be in sync with the direction of the market enough to be profitable over the long term.

An issue with equity market traders can be one of expectation and when expectations are not met people experience emotional hurt. Once an uptrend starts and the ‘herd’ get on board, then the expectation becomes that it will continue indefinitely and traders and investors alike will sit back and watch the successful trades roll in and their bank accounts continue to grow. Much as we have seen up until late 2007.

For those that get onto a successful system, such as SPA3, relatively early in the move, the profits are indeed substantial and the trader’s overall equity expands significantly. When the system gets out of sync with the direction of the market, as will occur with every system, and a drawdown occurs, these traders are more easily able to weather the storm, financially and mentally, as the equity dip is from profit as opposed to investment capital. The problem occurs though for those that began trading the system a few weeks or months prior to the beginning of the drawdown. In this case, the losses are either from initial capital, or the profits that they were able to initially make, are quickly eroded. The loss leads to emotional hurt manifested through high levels of frustration, even anger, or feelings of betrayal and revenge which, in turn, often ends with the trader deriding the system and even ceasing to trade it altogether. They then move to another method and maybe even different trading instruments until the drawdown occurs again. And then they move again, ensuring a lifelong cycle of inconsistency.

The only way to handle the drawdowns that occur within any trading system is to stick 100% to your trading plan so that when the system synchronises with the direction of the market again the portfolio can rise out of drawdown. If it is a robust system that has existed for many years and traded across a wide variety of market conditions then it is highly likely that the drawdown will end and when it does the system will return to delivering profitable trades and consistent profits, eventually making a new equity peak.

SPA3 for example, has returned just under 18% compounded return per annum over the past 7¾ years, compared to just under 4% for the Australian All Ordinaries Index over the same period. This includes -29% drawdown during the -41% 2007/2008 bear market. I know that it is tough when you are experiencing drawdowns because I, like you, am also in SPA3 drawdown. But it is during periods of drawdown that we grow as traders and learn about ourselves and how to trust and surrender to our edge and processes. If you cease trusting your edge as a result of drawdown then what will you trust when the market turns again? I know and trust that the SPA3 drawdown will end with a new equity peak through profits made when the market rises again.

The key to success when trading is not so much what you make when your system is generating profits, but how you manage it and yourself when it is not! It doesn’t matter what happens, it is how you take it that counts.