Trading Forex Live: Learning About Your Drawdown Tolerance

Two traders are given the exact same tools. They are given a package of strategies with successful simulated and live trading records and they are both given instructions on how the systems are meant to be used. After three years one of the traders has lost a significant amount of money while the other has made profit. This scenario is repeated very frequently in Forex trading and speaks about the reasons why some new traders will fail even if they have all the tools that would be necessary for their success. On today’s article I will talk about the main reason why the above happens and what new traders can do to avoid this type of scenario. We will go into the importance of knowing our own risk aversion and how we can find out if we are trading beyond our own capabilities.

Perhaps the most important characteristic a trader should have is to be able to always make rational decisions. By this I mean that a trader should be able to know that his/her decisions are taken according to a set of criteria that has the largest probability to lead to long term success. However making rational decisions is one of the most difficult things to master in trading since emotions play a big role when people are risking hard earned cash and additionally they are expecting some – and many times a huge – return on their investment. When a person has decided to risk some money to make more money, the power of fear and greed can start to takeover a trader’s decisions. Everyone who fails at trading has fallen to these pitfalls, making decisions that are not rational but based on impulses derived from either an instinct to preserve capital (fear) or the desire to make more out of it (greed). It is however important to remember that the key is not being emotionless – like a rock – but to feel emotions and avoid making decisions based on them: to have emotional intelligence. 

In my experience dealing with new traders – which I believe has been very significant at Asirikuy – I can say that nothing causes more irrational trading decisions than inadequate risk taking. Most new traders do not have any idea of what their drawdown tolerance is and therefore they start to make decisions based on the profitable side of things. On paper a 30-40% drawdown doesn’t sound that bad when the simulations show that you are to expect a 30-60% average annualized profit. Many new traders assume that systems will not fail and that they will always be able to stomach these drawdown figures on “faith”, with the “knowledge” that there will be a light on the other side of the drawdown tunnel. However they fail to take into account two very fundamental factors about drawdown periods.

The first important factor is that drawdown periods generally have extended lengths and new traders tend to ignore the importance of living with a drawdown for an extended period of time. Most systems and portfolios will have drawdown periods exceeding 200 days and some will even have drawdown periods amounting to 1-2 years. Most new traders will never be able to stomach these drawdown periods because the depth and length of drawdown periods compound in order to create a profoundly disturbing psychological effect. A trader could probably live with a 20% drawdown if it lasted for a few days but if the trader needs to look at the account every day for 5 months and only sees a bad drawdown figure, chances are that this person will at some point stop trading the system in order to relive the psychological pain caused by the financial loss.

Another important point is that real live trading drawdowns will always be worse than the maximum historical drawdowns seen in simulations. This is a consequence of both hind-sight in simulations and the simple nature of trading that expands system drawdowns as the market evolves into new territory. Statistically speaking the worse drawdown scenario that should be tolerated can be estimated through Monte carlo simulations but this level is often close to double the historical maximum drawdown. New traders tend to push the historical maximum drawdown to a level that they picture to be tolerable (which means they can handle it for very short periods of time) and they panic when this level is reached in live trading for extended periods of time. When you understand this combo it becomes easy to understand why it is so easy for new traders to fail, even if they have access to all the tools necessary for successful (or at least adequately risk-managed trading).

New traders always choose to trade at a risk level higher than their real risk tolerance with a complete ignorance of how they will feel and act when they reach statistically expected drawdown levels for long periods of time. The lack of knowledge about their own reactions to extended drawdown depths and lengths leads to the taking of irrational trading decisions that ultimately lead to trading failure (which means unplanned losses, lack of ideas of how to continue, averaging down, manual intervention, etc). New traders are doomed to go into this cycle and come out very frustrated unless they take the necessary steps to understand what their drawdown tolerance is and trade according to it. But how can a trader learn how something feels before living it ?

The answer is that you cannot. If you want to know your risk tolerance you need to trade real money but you need to do so in a way that allows you to learn with the minimum possible loss or irrationality. The first piece of advice is to start trading using cent accounts, using less than 1K USD, at a level of risk that you consider appropriate. The second piece of advice is to trade this account – using whichever algorithmic setup you decide to use – for at least one year before you decide to move into higher risk territory. This first setup will allow you to learn how you feel about making and losing money and when you start to go into emotional territory that might cause you to make bad decisions.

The most important thing you need to do is to take note of how you feel about your account. Write down your daily emotions when you look at your trading equity and make sure you also write a note if you feel like you would want to increase your risk, decrease it, stop trading the setup, change the setup, etc. By following this log you will be able to see if you’re getting emotional or if you are being completely unaffected by changes in your trading equity. A good trader is not moved to make decisions by good or bad emotions. Making more profit or going into a drawdown shouldn’t make you happy or sad to the point that will make you change your trading setups. If you’re feeling emotional about your trading, your risk level is too high. When you feel emotional with a given risk level  – for example if you feel overly excited or depressed if a trade was a winner or a loser – you need to lower your risk till you feel nothing with each individual trade outcome.

Hopefully by following this advice you will be able to know yourself better and learn what your real risk tolerance is while incurring in the least possible financial loss. If you would like to learn more about algorithmic trading and how to design and use trading setups please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)

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