Handling Drawdowns is not "Optimal"
By Dave Mabe
This month's MabeKit Mastermind covered systematic ways to reduce size during drawdowns and increase it when hitting new highs.
Two long-time profitable traders presented their approaches to this problem.
There was a long discussion about the topic, but here's one quote that really resonated (edited slightly for clarity):
J.M.:
[When you're trading a profitable strategy, ] the optimal thing is to never change anything, no matter how big the drawdown is, so that you're gonna make the most money. But the reality is that you might not be able to deal with those drawdowns, you know, in real life, right? So people will say, "Oh, well, it's 1% of your account or 2% of your account," but the bigger you go, it doesn't really go in percentages; it goes in dollars.
Dave:
This is a great point.
Making adjustments due to drawdowns is not, technically, "optimal."
But it is necessary!
It's easy to try to think about sizing in percentage terms. For example, sizing based on a percentage of your account.
But when you're trading a profitable strategy, those small percentages of your account can turn into lots of dollars.
And at some point, no matter how hard you try not to, you'll think about profits and drawdowns in terms of dollars.
(There's a reason you don't think about your salary in terms of a percentage of U.S. GDP.)
When you're looking at a strategy's equity curve from a backtest and imagining what it will be like to trade through the drawdowns, it's easy to think, "No big deal, it's only a X% drawdown, I'll just keep doing what's 'optimal' when that happens."
But reality is much different.
If you get emotional during a trade, systematic trading will definitely help.
But the emotions don't go away - they transfer to another area of your trading: sizing decisions.
Most traders size up too quickly.
You don't hear it mentioned much, but many traders size down too quickly, too.
It's because these decisions are emotional and ultimately based on dollars, not percentages.
A pre-planned approach to sizing decisions helps when drawdown pressure is mounting, but also when things are going well.
-Dave
P.S. Questions about the MabeKit Mastermind group? Hit reply and let me know.