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Managing Risk in a Drawdown

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By David Hobart, Director, PsyQuation Consulting.

Having drawdowns is part of the trading business. They are rarely pleasant, but with the right risk management approach, they can be experienced without unnecessary discomfort.

There are many different schools of thought about how to manage risk for different strategies. Regardless of your strategy however, it is important to understand your personality type and define a context for risk management that works for you, not against you. The context I use inside risk management is that my rules have been put in place to protect me. Given that I am generally risk averse, I need to be able to focus on making money, rather than worrying about losing it. By having the right risk rules, I am free to trade without fear.

Conversely, if I were more naturally a risk taker, I would have rules that caused me to be more risk focused and aware, thereby limiting the depth of my drawdowns.

Define your Line

All trading strategies should have a line in the sand which defines the maximum tolerance for a drawdown. This line defines the risk of ruin and consequently needs to be defended at all costs. By defining it in your strategy, you are declaring your commitment to protecting your capital. This commitment is critical to managing risk well.

In my trading, I have a 25% peak to trough drawdown rule which if breached would result in me being out of the game. This rule forms the basis from which all other risk rules are built. From here however, different methodologies are suited to different strategies.

Discretionary vs Systematic

Running a discretionary strategy, I manage my risk by reducing the incremental capital at risk per trade as I move into drawdown. Firstly, I define risk capital as 25% of total funds at my peak performance high water mark. I then calculate my risk per trade as a percentage of this risk capital. This means that as I go into drawdown, the capital I risk on each trade reduces quite quickly, limiting the depth of any drawdown. This strategy is particularly helpful for discretionary strategies where past drawdowns are not necessarily indicative of future ones.

In a systematic process, the entry and exit methodology can be more accurately measured and back tested. If your testing methodology is true, it is typically easier to pre-define per trade risk as you have a sound statistical basis for estimating the depth of future drawdowns.

Regardless of whether your strategy is discretionary or systematic, knowing that the risk rules surrounding your strategy are robust will allow you to trade without fear when you have been experiencing a period of losses.

About David Hobart

David has been a trader and portfolio manager since 1994. He has managed teams of traders for global investment banks and hedge funds including BT, Macquarie, ABN Amro and Blue Sky Alternative Investments. He has worked with numerous traders and portfolio managers as a trading coach/performance consultant. For a detailed review of David’s CV, please see his LinkedIn profile.

If you would like to find out more about David’s trading coaching/performance consulting programs, check them out here or email david@psyquation.com .

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