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Surviving Drawdowns

It's turning into an exceptionally tough year for long-time traders who usually make money, day in and day out. Of course, the losing bug hasn't infected everyone. It really depends on how your strategy has adapted to this wicked tape, and whether your market vision is clear enough to keep you out of trouble during periods of high risk. In fact, I know an automated-systems daytrader who's having his best year since 2000 because the Market Volatility Index (VIX) has risen over 20 and stayed there for many months. For him, this twitchy and unpredictable market is offering the ideal environment to execute his fast-fingered strategies.

But it's been a major challenge for position traders who measure holding periods in days and weeks, not minutes and hours. As Doug Kass notes, the 2008 market has no memory. This amnesia is a major drag on profitability when your Forex trading systems depends on logical price development from session to session. From my vantage point, the need for absolute discipline is the most important message in the 2008 tape. In better markets, we can get sloppy with our position choice and timing but still make money. However, anything less than perfection in this environment will trigger major losses or wash you out of the game permanently.

Feeling the Pain

For many traders, this is their first major drawdown of the decade, or at least since the bear-market low in 2002. Unfortunately, the market has a way of balancing the books, and many of these folks have given back a fair share of their long-term profits. Sadly, common sense indicates that things will get worse before they get better. Drawdowns trigger all sorts of psychological and logistical issues. Realistically, it's really tough to turn on your trading screen after incurring a series of losses that might have been avoided in better days. The assault of red ink undermines your confidence and makes you second-guess all the strategies that worked so well in the past.

On one hand, this pain is a wakeup call to adjust your strategy and reduce risk exposure. But even the best traders can't avoid drawdowns entirely. At its core, these losses are just a natural outcome of playing the financial markets. Of course, I doubt that piece of wisdom makes you feel any better when the market is beating you up. Emotional extremes are difficult to manage during a major drawdown period, and they can prolong the pain unless the trader gets control fast and maintains a good attitude about losing money. I know this sounds hard, but despair and profit rarely travel together. And it's very easy to turn a string of moderate losses into a full-blown disaster.

Change Gears

Strategic changes to your trading methodology will lower the emotional fires during a drawdown period. At the top of your list: Reduce position size and don't try to recoup your losses in one high-risk trade. This is a revenge-motivated activity that sets up market players for a catastrophic event that can take them out of the game permanently. The key goal during a drawdown is to preserve capital until conditions improve. Smaller positions let traders get their minds into a healthy state and back in harmony with the market flow. The smaller profits obviously won't undo the prior damage, but they will help to re-establish the methods and workflows that paid the bills in the past. Review your trading plan in detail, looking for major flaws that are aggravating the loss cycle. It might feel good to blame the 2008 market for your failure to make money -- we all do that at times. But in reality, that's just an excuse that blinds you to the real reasons for your dwindling capital.

Reality Check

Drawdown periods can force traders to experience a level of impotence that can be very frightening. Many discover their profits came during a period during which everyone else was making money. They finally realize those happier times induced ego gratification and a false belief that they had become genuine market players. This wakeup call has two common outcomes. First, it forces marginal traders to wash out of the markets and move on to safer hobbies. Second, it motivates serious-minded traders to discover how the markets really work and what it takes to survive in all types of environments, good and bad.

Identify your "fail-safe" drawdown level early in your career. This is the maximum amount you're willing to lose before turning off your screen and walking away from the market. This hiatus need not be permanent. It's just a recognition that things have gone wrong and a period of self-analysis is needed before taking on new risks. This vacation from the market lets traders examine personal issues that may be hidden in the heat of day-to-day battle. It also allows them to get to bedtime without fresh losses weighing on their minds. This simple abstinence often ends the drawdown cycle and fosters instant success when they finally return to the action.

The pain of a drawdown period will turn you into a more profitable trader if you listen closely and adapt quickly to its embedded messages. But the same pain can destroy your ambitions and capital if you choose to ignore the experience. It's really up to you: Do you want to fight the market, or do you want to make money? The key difference between good traders and bad ones is how they turn their drawdowns into acts of personal power. We're all shocked to discover we're just mortals when the tables turn and we start to take big losses. But the experience exposes us to the truth serum we need to survive and prosper in the long term.

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