Tuesday, June 17, 2014

Things to Consider in Setting Money Management Rules – Part 1: DRAW DOWN

One important part of money management/position sizing is the ability of a trader/investor to avoid large draw downs or limit the draw downs to a certain percentage of the trading capital/portfolio.
If the traders/investors always take high risk in their trades, they are more likely to experience disastrous drawdown. Therefore, the way to avoid it is by limiting the size of what you are prepared to lose / risk in any single trade to a certain percentage of your total trading capital/portfolio (i.e. proper position sizing).

A draw down is defined as a reduction in the account/portfolio from its highest point resulted from a losing trade or series of losing trades during a certain period.
A draw down is measured in terms of a percentage between a recent peak to a recent trough of the account/portfolio.
If all your trades were profitable, you will never experience a drawdown. The calculation of draw down would begin only with a losing trade, and continue so long as the account hits new lows.

With regards to drawdown, it is important to understand that the percentage return that you need to make in order to get back to breakeven is bigger than the percentage of losses you experienced.
So, if you lose 10%, you cannot gain back to breakeven by getting 10% return in the next trade, but it would be more than 10%.
For example:
Suppose your initial capital is $1000. If you lose 10% ($100), the remaining capital will be $900. If in the next trade you make 10%, your capital will only reach $990, still losing $10 (or 1% loss from the initial capital). In order to recover to breakeven, you will need to make $100/$900 = 11.1% in your next trade.

The following table shows the percent return required to recover to breakeven when you experience a certain percent of losses (drawdown).

From the table, we can see that as drawdown increases, the percent gain required to recover / get back to breakeven increases in a much faster rate.
For instance, when you lose 20%, you would need to make 25% return on the remaining capital to get back to breakeven. However, if you lose 40%, you have to gain 66.7% to breakeven.
Further, a 50% drawdown would require a 100% return, and drawdowns above 50% require huge returns in order to recover to breakeven.

From here you can see that the more you lose, the more difficult for you to make it back to your original account size. When you risk too much and lose, your chances to recover your capital fully would be very slim. It is not only because you are merely left with much less money in your account, but also you have to deal with the negative psychological impacts of the drawdowns.

Therefore, it is extremely important that you have good money management rules, so that when you experience losing streaks and suffer from drawdowns, you will still have enough money to stay in the game.
With a proper money management, you should only risk a small percentage of your account in each trade, so that you can survive your losing streaks and also avoid a disastrous drawdown in your account.

Continue to: Things To Consider in Setting Money Management Rules - Part 2: RISK TOLERANCE

Go back to: The Importance of Money Management / Position Sizing

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