Defensive Money Management Explained: When Your Trading Style Fails
Quite a number of fund manager and pro trader friends have experienced significant drawdown so far in year 2017. Partly thanks to the uncertainties of the current geopolitical environment, these veteran professionals all have expressed their frustrations with their performance. On the other hand, their observations and responses to the current situation they are facing are very useful for all traders from any background.
(Part of Defensive Money Management Explained series)
Is It You Who Failed
These professional traders often reflect on their own performances. The regular check up on themselves give them an understanding of where they are in terms of relative performance against the markets they trade. And it is not an ego boosting practice. If you think that way, you probably never conducted any self evaluation.
During drawdown period, it is easy for many traders to start questioning themselves whether they are doing their best or, in extreme cases, suitable to trade at all. In contrast, the long lasting professional traders always question themselves if they are doing their best. Without the regular monitoring, one will not have an objective reference whether one has already done the best.
This difference in self evaluation helps the better traders to handle their drawdown period with much more clarity and objective understanding on what has to be done. In other words, they can figure out if they are the reason who fail in the current market environment or if it is their trading methods that fail in the current market environment. Knowing exactly what went wrong helps these professionals sailing through tough times.
Is Your Trading Style Failing You
By ruling out the human factor objectively, the answer to the reason of significant drawdown points to the trading style being used. According to my friends, they realized that their trading styles have, over the years, evolved into fitting the trading environment shaped by the central banks and geopolitical factors. Hence, once these underlying factors changed, their trading styles that are optimized to extract profit from such environment become obsolete.
Notice that it is not the overall concepts behind their trading methodologies failing them. After all, all long lasting trading concepts like breakout and trend following still work fine. It is the specifics in applying these concepts, for which these professional traders unconsciously optimized them, that failed to work in the current environment.
One trouble with many traders is that they are attached to the method they use to make money. The more specialized their method is, the more likely they cannot let go of the style. The more profit a trading method has been generating, the more likely the trader would have developed feelings for the trading method. In such situation, as emotions are involved, many traders would make the mistake of escalation of commitment, for which they would oversize trading the same method hoping that the past glory would return and that huge profit will follow to recover all the losses.
Quite a number of my friends made this mistake earlier this year. Thanks to their self discipline and trading plans in place, they managed to stop themselves from losing too much money. For beginner traders or traders with lesser experience, they would probably be wiped out already.
The Difficulty in Telling What Went Wrong
Objectivity can be hard when we have to evaluate ourselves. To pinpoint what went wrong after significant drawdown is even harder because we are likely very upset from the accumulated losses already. One way to ensure we can figure out what went wrong is having deep understanding of our trading method and why it was able to make money from the market in the first place.
For example, if you trade a counter-trend method, it depends on the exhaustion of a move to produce the pullback that you can extract profit from. This is the foundation of counter-trend play. Having this overall understanding of the method tells you how it can lose money. If the exhaustion identification method you use does not work in the current market environment, your entries will be bad and your optimized stop loss will fail. If the volatility of the market does not behave the way you expected, your stop loss will not be able to keep you in the trade even if your entries are reasonable. Your exit methods may fail to work too as that depends on precise timing to get out of the market before it resumes the current trend.
Being able to analysis our trading method part by part is one of the better ways to figure out the reasons behind the breakdown of the performance of our trading style. It can be very tedious. For some trading styles, especially the swing trading ones that last for weeks, due to lack of trades, it will be very difficult to tell what went wrong until after months of losses accumulated.
Risk Control Saves the Day and Your Trading Career
At the heart of handling significant drawdown situation, it is risk control that keeps us from making fatal mistakes. Just stop trading after big losses does not help much since you are going back to the same routine anyway. If it is your trading style that is no longer working, you will just accumulate more losses down the road. Our experience from our past performance can act as a guideline telling us when to stop trading so that we can audit ourselves and our trading methods. But it may not be objective enough to tell us to stop trading before it is too late.
Seeing drawdown of half of our trading capital is a bit too late for discretionary traders to stop trading with their current method. I suggest starting the evaluation process when 20-25% drawdown happens. For mechanical traders, since they know well ahead from backtesting what the worst drawdown was historically, they can give themselves clear guideline when to stop trading their trading systems. Whether they will honour their own rules is a separate question.
Since discretionary traders do not have the luxury of knowing the historical drawdown of their trading styles, using dollar amount thresholds usually works pretty well. For example, if a discretionary trader has initial capital of $50,000, first sign of trouble is losing $10,000. Remember to put this in the written trading plan, that once such drawdown is reached, a comprehensive self evaluation will be done, otherwise, it is not likely you are going to force yourself to do it.
Fear of Losing It All
When facing huge drawdown, there is one emotion that surfaces more often than anything else. It is the fear of losing it all. Even a couple of my friends, who have at least 30 years of trading experience under their belts, have a sense of helplessness after their recent big drawdowns. They cannot help themselves from imagining that their career, lifestyle and even family will be heading for the worst. The trouble is that their fear has a reasonable ground, making it extremely stressful for them to carry on daily tasks.
This crippling fear comes from the fact that my friends identifying themselves only as very successful trader or hedge fund manager. When that identity is threaten, they have no other emotional support to lean onto. They cornered themselves emotionally.
To be able to bounce back, one must detach oneself from the losing trades and accumulated losses. It is like football players in a football game. They may have lost several games in a row. But those teams that focus on developing better skills and strategies eventually will come out ahead.
Detachment is not the same as shifting the blame onto others, which is exactly what many unsuccessful traders do. In fact, detachment allows oneself to own the failure and move on to the more important task on hand. Namely, finding out what went wrong quickly so that the same issue will not affect future performance.