Good Luck and Bad Luck in Trading – How to manage drawdowns

Equity curves do not move in a straight line. Trading is a very bumpy ride. The trader has to experience drawdowns, probably weeks and months without a profit. Then there are times when everything goes our way. Every setup seems to work. Our account history is almost green only and we are seeing new highs in our Equity.

On a fundamental level, the result of each individual trade is random or uncertain. Compare it to a coin flip. The coin never alternates between Heads & Tails like this:

H-T-H-T-H-T-H-T-H-T-H-T-H-T-H-T-H-T-H-T-H-T-H-T-H-T-H-T-H-T

Instead, the random nature of a coin flip will result in segments of Heads and segments of Tails:

H-T-[H-H-H]-T-H-[T-T-T]-[H-H]-T-H-T-[H-H-H]-T-H-[T-T]-[H-H]-T

That explains, why also in trading, we do not see the equity curve as a straight line. The trader must be prepared for any streaks of good luck and any streaks of bad luck.

Let us start with the streaks of bad luck. Even if we have a winning trading system, this system will experience drawdowns. Drawdowns are what makes a trader anxious, makes him question his system, lowers his confidence etc. Drawdowns are the result of randomness in the markets which causes temporary losing periods. Losing periods may last anywhere from weeks to years. The longer and larger the drawdown, the more the trader will question his strategy.

Drawdowns are the main engine, that drives the trader into tweaking his trading system and potentially wipes out any edge in the market. Lower self-confidence causes the trader to miss good setups which potentially may recover the trader from the loss.

On the other hand, we also have streaks of good luck. This is the time when everything goes your way. Some might say that a streak of good luck can only be good. This statement is absolutely wrong. Streaks of good luck can be almost as harmful as streaks of bad luck. Streaks of good luck are the main reason for overconfidence and carelessness. When everything goes your way, your ego starts to kick in. You think that you are the best trader in the world. Once this happens, you are entering a very dangerous zone.

Winning periods increase your ego. You start taking sub-optimal setups. You may start trading bigger lots. You stop thinking about fundamental risk management etc. Then, when the bad times come, you realize how little control you have in the markets. Hopefully, you have not blown up your account by then. 

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At FTMO, we offer a solution to this problem. A good way to deal with randomness is to simulate any possible outcome. If you know that your strategy has drawdowns around 20% and you are just in an  11% drawdown, your strategy is still performing within your expected drawdown range. You should only worry about your strategy, once it exceeds a drawdown of 20% and you should put a hard stop on your strategy, once the drawdown reaches 30-35%.

In the following graph, we are going to simulate an equity curve based on the following parameters of a winning system:

 

First, let's look at our inputs. We are simulating the equity development of an account of the size of 10.000 units. The parameters of our strategy is a win rate of 50% and a RRR of 2:1. Let's also assume that we risk 1% of our capital on each trade.

The number of each iteration on each trade is 200, in other words, we are simulating 200 trades per line. In this experiment, we will be simulating 5 lines.

Looking at the equity levels, it is very clear that our strategy shows a profitable tendency. However, by adding the element of randomness, not every line behaves exactly the same. Curve 5 realized a profit of 13.600 units whereas Curve 4 yielded only 6.400 units. This so-called variance is an aspect of trading that all traders must accept. This experiment proves that past results definitely do not project future performance.

Our goal is not to calculate how much money we are going to make in the future but rather, we want to look at every possible outcome and be prepared for it.

Let's look at drawdowns for example. The maximum drawdown out of all lines is 8.7%. We can consider it to be a very good number if we look at it in terms of risk management. The average max drawdown out of all lines is 6.62%. The question now is, should you be nervous if you are approaching, for example, a drawdown of 5%? Absolutely not! According to our simulation, we have seen drawdowns as high as 8.7% You should, therefore, start worrying if you approach a drawdown of about 10%. With this in mind, bad luck should not affect your psychology as much because we are already expecting such drawdowns to happen. Keeping calm and strictly following your strategy is what you should focus on.

Many people say the following: 'Expect the worst case scenario and double that'. If the maximum expected drawdown is 10%, you should be ready to lose at least 20%.

Let's also look at consecutive losers. In our experiment, we've seen a streak of losses up to 10 times in a row. It is not very likely but throughout your trading career, you should always expect the worst outcome. Again, should you be worried, when you lost 7 trades in a row? Not at all! Stay disciplined, you are already 'expecting' to lose this many trades.

I hope that you enjoyed this little introduction to the Equity Calculator. If you are interested to try our Equity Calculator, you can sign up for our Free Trial in the box below. The Equity Calculator and other very useful applications are free for all FTMO Traders.

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