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Learn 4 Causes of drawdown & 5 ways to reduce maximum drawdown in your trading



Drawdown is one of the most important topics to understand and master when you learn stock trading. It is given a lot of lip service in trading system development literature but there is very little practical information on how to manage and reduce drawdown in your stock trading systems.To get more news about how to control drawdown, you can visit wikifx.com official website.

Most stock traders generally understand that you don’t want to have large drawdowns and you want to limit your risk, but realistically, most traders focus on return when they are developing trading systems. In this post I am focusing on the drawdown side to bring up some of the issues and share some interesting issues and ideas for you to consider in your trading system development.
I first want to give a clear definition of drawdown in stock trading and trading systems, just to make sure we are working from the same baseline. When you run a back test, you get an equity curve that shows you how your portfolio would have grown over time if you had followed those trading rules in the past. At any point on the back test, it might make a new high relative to the previous equity values in the back test. As you move forward from that new high, it could keep going up, in which case there’s no drawdown or the equity could fall, in which case that’s a drawdown.
At any point on your equity curve, you’re looking forward to see what the largest percentage decline is from a equity high to a subsequent equity low. This percentage decline is the drawdown that your trading system experienced from that point. In Amibroker when you run your backtest you get two main graphical outputs.

The underwater equity curve you get when you backtest your trading system in AmiBroker shows you the percentage drop from the highest point on your equity curve to the subsequent low. This shows you what the percentage drop in your equity would have been had you been trading the system at that time.

You should be aiming to minimize the drawdown in your trading as much as possible for a given level of return… or maximising your returns for a given level of drawdown. There is always a tradeoff between drawdown and return that we have to work with as systematic traders.So there’s one thing which is often misunderstood when new traders think about drawdown, and that is the difference between trade drawdown and portfolio drawdown. Many traders will freak out or get concerned when they have a trade and it dips 30% or 40% before exiting or before going on to new highs. They have already planned on a drawdown tolerance of say 20%, but here they are with a trade drawdown of 40%. The conversation usually goes something like

There is actually nothing wrong because on a trade basis, the drawdown can be very different than on a portfolio basis where you’ve got many trades compared to an individual trade level. When you backtest your stock trading system, the portfolio level drawdown is the one that you need to be consistent with your psychology and your risk tolerance.

The trade level drawdown is quite different to the portfolio drawdown and is worth understanding and investigating because you can get nervous on an individual trade. Your ability to follow your system can be sabotaged by an individual trade. Even if that individual trade is within the bounds of what’s normal for the system and even if you’re not in a bad drawdown at a system level, one trade can still cause you concern.

When you are looking at individual trade drawdown you use the maximum adverse excursion from the entry of your trade to understand how far each trade can move against you according to your backtest. The Maximum Adverse Excursion (MAE) on a trade can be much higher than your portfolio level drawdown tolerance because many trades combine together to form your portfolio, so they tend to smooth each other out in the portfolio.So please do not get concerned about individual trade MAE if the system is achieving your objectives in terms of return and drawdown at a portfolio level. You can use Maximum Adverse Excursion data to find ways of improving the accuracy of the entry signals in your trading system, but it certainly should not be used in any discretionary way to close a trade that has not generated a sell signal on its own.

The first and most important consideration is your trading psychology. It’s your money, and you want to do something cool with it. You want to buy a new house / car / freedom etc with it. Whenever your account drops, that trading goal is threatened, whether you like it or not. The trouble is, your trading goal is threatened in direct proportion to the size of your drawdown!

The trouble we then have is that our animal instincts kick in – whenever we feel threatened we move into “Fight or Flight” mode. It is a survival instinct that is hard to avoid (something to do with a few million years of evolution – The Fight or Flight response is explained here) When we feel threatened as a species, humans stress levels go up and our blood is redirected to our muscles to get us ready to either fight for survival or run (Thus the name ‘Fight or Flight’) the problem with this is as soon as this happens our intelligence falls because our body is ready for action… it is no longer ready to make rational and sometimes complex financial decisions.