Avoiding the Risk of Ruin from a Draw Down

Having a sound money management strategy is very important in order to avoid the risk of ruin from losing streaks and drawdowns.

However, please bear in mind that although you might have implemented strict money management rules, you still cannot avoid drawdown at all. Drawdowns are inevitable.

Therefore, you need to know how to stop the drawdowns, so as to avoid the risk of ruin and allow you to survive a period of losing streaks and drawdowns.

However, the good news is, to stop a drawdown is simple. All you need to do is just stop trading. That’s it!

But, what’s next? What can you do when you stop trading?

You can still continue to monitor the markets, your favourite stocks and indicators.

By not being in the markets, you will be able to sit back and analyze the situation without the emotions.

 Here are some of the things that you can do while you stop trading:

 

1) Make sure that you fully recognize and understand all of the reasons that caused your drawdown.

There are 2 possible reasons:

a) Yourself

When you experienced a drawdown, you should always look within yourself first and review your recent trades or trading journal, to ensure that nothing has recently changed.

Ask yourself questions, such as:

* Have you been following your trading system/rules and manage risks properly? Did you break or modify any of the rules knowingly or unknowingly? Did you “force” any trade?

* Any changes in your trading styles recently?

* Is there any major life event that affects you, physically or psychologically?

* Any distractions that hinder you from focusing?

 b) Market Conditions

Market condition may affect the performance of your trading style/methodology.

Sometimes, there are some market conditions that are more favorable to your style/methodology and give you a better chance to be profitable, or vice versa.

But when the market changes, it becomes more difficult for you to trade in an unfamiliar conditions.

When that happens, you may need learn and understand the market condition better and be extra careful / selective in your trading in the sector or stock selection, market timing, etc. Sometimes, it is even wiser to stand in the sideline and watch the market, rather than jumping in an unfamiliar market condition.

 2) Once you have identified the causes of your drawdown and made some plans / strategies / rules to tackle the problems, you can start again by doing paper trading to test it. Remember to keep records for every single trade you made in paper trading.

Note:

You can find some useful tips for paper trading from the earlier article: 5 Tips For A More Effective Virtual / Paper Trading

3) When you’re consistently profitable in paper trading for some time, you can then slowly start with real trades again to engage your emotion into the trading. Start with small trades first. When the trade is profitable, you can gradually and slowly increase your position size.

If you encounter losses again, then scale back in your trading, or go back to paper trading, if necessary.

 

4) Repeat the above steps until your trading performance improves.

Remember to always keep records for every single trade, including the notes about market conditions. Learn from the past experiences, so that you can avoid the same mistakes and would be better equipped to tackle the future drawdowns.

To view the list of all the series on this topic, please refer to: Money Management / Position Sizing 

Related Topics: 

* Understanding Implied Volatility (IV) 

* Understanding Option Greek 

* Understanding Option’s Time Value 

* Learning Candlestick Charts 

* Options Trading Basic – Part 1 

* Options Trading Basic – Part 2

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Things to Consider in Setting Money Management Rules – Part 3: HOW LONG YOUR CAPITAL CAN LAST

In setting money management/position sizing rules, you should also consider:

1) How long your capital can last, or

2) How long your account balance will drop to the risk tolerance you’re willing to take after going through a series of successive losing steaks.

The answers to these questions will depend on:

* The initial capital/account balance

* How much to risk per trade

* The percentage risk tolerance (for Qtn 2)

 

Suppose your initial capital is $10,000.

If you money management rule is that you would risk maximum 5% of the initial capital (i.e. 5% x $10,000 = $500) in each trade, your capital will be all wiped out after 20 successive losing trades.

Suppose your risk tolerance is 25% (i.e. 25% x $10,000 = $2,500), your balance will reach this level after 5 losing trades in a row.

Notice that the above rule is different from what has been discussed as Option 2 in the previous article.

In the Option 2, the maximum risk in each trade is 5% of the remaining account balance.

Hence, with the initial capital of $10,000, after losing 5% (i.e. 5% x $10,000 = $500) in the 1^st trade, the balance will be $9,500. Then, the 2^nd trade will risk 5% of the remaining balance (i.e. 5% x $9,500 = $475), the balance will be $9,025, and so on.

Using this rule, to answer the above questions is not that straightforward. However, this rule is more common to be used by traders.

Hence, let’s try to formulate it.

Trade 1:  $10,000 x (1 – 5%) = $9,500

Trade 2: $10,000 x (1 – 5%) x (1 – 5%) = $10,000 x (1 – 5%)^2 = $9,025

Trade 3: $10,000 x (1 – 5%) x (1 – 5%) x (1 – 5%) = $10,000 x (1 – 5%)^3 = $8,573.75

Trade n: $10,000 x (1 – 5%) x (1 – 5%) x (1 – 5%) x …… = $10,000 x (1 – 5%)^n

Putting in a formula form:

Where:

C = Initial capital (Initial account balance)

R = % Risk for each trade

n = Number of trades

B = Remaining capital/account balance

To answer the above two questions, we need to solve n, which can be done through the basic principles of logarithm, as follows:

Please note that, to answer Qtn 1, we CANNOT set the remaining account balance as zero, as logarithm function will never touch zero line. Hence, we should assume a certain amount, which is small enough and can be deemed as “no more money for trading”.

For example:

Assume we deem $100 as small enough to approach a situation of “no more money for trading”.

Continue with the above case, the values of each variable are:

C = $10,000

R = 5%

B = $100

To find how long the capital can last, we solve n:

Note: Always round down the result.

Likewise, to answer Qtn 2 where the risk tolerance is 25% (i.e. 25% x $10,000 = $2,500), the values of each variable will be:

C = $10,000

R = 5%

B = $10,000 - $2,500 = $7,500

Solving n:

Alternatively, we can also use another method to answer the questions, which is using Tabulation, as what has been done in the previous article:

Using this way, after inputting the formula in MS Excel accordingly, we just need to “drag the row” to copy the formula until we reach the desired account balance.

From the above table, the answer for Qtn 1 is highlighted in yellow, whereas the answer for Qtn 2 is in green.

For reference, the following are the formula used for both methods:

Go back to: Things To Consider in Setting Money Management Rules – Part 2: RISK TOLERANCE

To view the list of all the series on this topic, please refer to: Money Management / Position Sizing

Related Topics: 

 * Understanding Implied Volatility (IV) 

 * Understanding Option Greek 

 * Understanding Option’s Time Value 

 * Learning Candlestick Charts 

 * Options Trading Basic – Part 1 

 * Options Trading Basic – Part 2

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Things to Consider in Setting Money Management Rules – Part 2: RISK TOLERANCE

In setting a suitable money management, you should also consider the maximum drawdown you are willing to accept, which depend on your risk tolerance.
In this case, do take into account the reasonable percent return required to recover to breakeven when you experience a certain percent of losses (drawdown), as discussed in the previous post.
Then, set money management rules based on your risk tolerance (expressed in terms of percentage of the total account/capital).

Just a simple example:
If you are willing to suffer from losses of maximum of 25% of your total capital, this means your risk tolerance is minus 25%. In this case, you should set money management rules and/or choose trading strategy that has a maximum drawdown statistics of 25% or less.

Consider two options of the following money management rules:
Option 1: Maximum of 2% risk (of the remaining account balance) in each trade
Option 2: Maximum of 5% risk (of the remaining account balance) in each trade

As can be seen from the above table, using Option 1 (max 2% risk for each trade), your account will drop to a level that is close to your risk tolerance of maximum 25% drawdown only after 14 consecutive losing trades.
In contrast, using Option 2 (max 5% risk for each trade), your account will even exceed that level only after 6 losing trades in a row.

Looking at another perspective, Option 1 will suffer 26.1% loss in the case of 15 consecutive losing trades, which would require 35.4% gain in order to be back to breakeven.
On the other hand, with the same scenario of 15 successive losing trades, Option 2 suffers 53.7% drawdown and will need 115.8% gain, which is much harder to achieve, to be breakeven. Although losing 15 times in a row is quite an extreme case, in reality it is still possible to happen.

Remember that although you might have implemented strict money management rules, losing streaks and drawdowns are inevitable.
Hence, you should set a sound money management strategy that aims to avoid risk of ruin at all cost, can survive a period of losing streaks, and also still reasonable to rebound to at least break even.

Continue to: Things to Consider in Setting Money Management Rules – Part 3: HOW LONG YOUR CAPITAL CAN LAST

Go back to: Things To Consider in Setting Money Management Rules - Part 1: DRAW DOWN

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2

Read More