How to avoid a large drawdown in your trading account

This is the kind of post that no one ever wants to utilize or need, because it will mean that they are either in a trading slump where most of their trades are going against them, or worse, they are capitulating their own portfolio with some horrible trading decisions, with each one only compounding the consequences.

5 steps to making back your losses

Here’s the issue with drawdowns: the more bad trades, or worse, the more bad decisions that you make, the harder it becomes to get out of that hole you are digging for yourself.

For example a 50% drawdown, requires a 100% return on the remaining capital just to get back to even. And let me just say, it is much easier to lose 50% than it is to make 100%. So, if you find yourself in this situation, you have to take a step back and re-evaluate matters.

Drawdowns and losses come with trading, the extent of those drawdowns and losses are what makes the biggest difference between successful traders, and unsuccessful ones. I have drawdowns, but my drawdowns are not big at all. To give you a little perspective, for many traders, it is common to have drawdowns of 20-30%. For me, a drawdown of 3-4% percent is huge. My profitability comes by containing the downside, because all the profitable trades in the world won’t mean anything, if losses and drawdowns are not properly managed.

So how do we manage the drawdowns, and when the losses come, what is the best way to make it all back? Here are five ways to manage the losses, drawdowns, and return to profitability quickly and expeditiously.

1. Don’t Revenge Trade

This is a hard one to avoid. Everyone is guilty of it. Whether it is going short on a stock you were just long on, or getting back in a trade that you had no logical reason for being in. It can also come in the form of maxing out capital, or worse, leveraging an account, and doubling down on a stock, believing that ‘this time’ it will work out.

Revenge trading nearly every time, simply digs a deeper hole for you as a trader. Now, I’m not advocating against getting back into a stock that you were stopped out of earlier, but if you do get back in, it has to be for more than just “getting back” to break even, or to get that money back. When the latter is your rationale for trading, you are indeed, “Revenge Trading”.

I’ve been known plenty of times, to try a stock three or four times. It is necessary at times, even though it can be exhausting too. There are many times where a stock will stop me out, and then the market bounces back, and the stock re-emerges again as a quality trade setup. If that is the best setup available, then yes, I will get back into that stock.

But you don’t get back in the trade, simply because the loss that you took on it before, doesn’t sit well with you.

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2. Keep position sizes the same

The doubling and tripling down on losing stocks has to be the absolute worst trading strategy, besides not using stop-losses. Not to mention the horrible thought of traders that engage in both! Traders justify doubling down because it lowers their average entry price, thus making it easier to get back to break even.

Though if you are doubling down, you are not considering risk and if you are not respecting risk, it means that you are probably not using stops.

Even worse you are trading with your ego, and it is telling you that you must be right on this trade. When you have to be right, you are throwing away everything that matters in successful trading: risk/reward, positions management, keeping losses small, and so, so much more.

3. Trade a smaller number of stocks

The worst thing you can do, if you have taken a beating from the stock market is to think you have to make it all back up, right away. This too, will lead to bigger losses. Often times, if I find myself on the wrong side of the market, and I am looking for the market to bounce off of oversold conditions, it isn’t unusual for me to play the bounce and be wrong a couple of times.

But I don’t do it with a huge part of my portfolio. Instead, I wait to see if my initial positions, perhaps 1-3 positions, can hold it together, and if they do, then I will gradually increase my long exposure. Before long, I have a great portfolio of stocks to work from.

RELATED: Fighting Stock Market Crash Paranoia in a Raging Bull Market

You cannot, however, go 100% back into the market everytime you think it is going to bounce. If you do, and the market continues to trend against you, you are taking an additional wallop against the entire value of your portfolio, rather than a portion of it.

4. Stay Patient, and increase your positions incrementally

I mentioned this briefly on the third point, but it is worth mentioning again here: timing a market bottom doesn’t require you going “All-In” all at once. Instead it requires you to dip your toes into the water and see whether one or two positions can work, and if they can, then add a third and maybe a fourth…and so on and so forth.

I don’t diminish the size of my positions when I trade in a market where I am experiencing a drawdown, instead, I choose to incrementally increase the number of positions in play. If I am in a drawdown, or on the wrong side of the market, I don’t make that money back by putting it all on the line. I make it back by exposing as little of my portfolio to further downside, until I can get back on the right side of the market and earn it back. As I become more profitable, I increase the number of positions in play.

5. Increase your stops as they become profitable

Profitable trades are great, but they are only worth anything if they can stay that way until the end of the trade. That can only happen by increasing the stop-losses on your existing and profitable trades. If you don’t do that, you are creating the possibility of your trades going from being profitable to becoming a loss, or as the street calls it, “Green-to-Red”.

These kinds of trades are the equivalent of throwing a “Pick-6” in football when you are at the opponent’s goalline. Instead of throwing a touchdown, you throw the interception and the other team takes it to the house for a touchdown of their own. In the end, the game swings 14 points against you. That is hard to recover from.

Likewise, when you let a 10% profit turn into a 10% loss, it is no different. You essentially just had a 20% swing against your interests. Properly managed, you should have gotten out with around a  7-8% profit, at least, and then move on to the next trade. But without properly managing the risk, you are then finding yourself in a position of hoping to profit from the next trade and make back some of those losses, and missed profits. And I say “hoping” because we are only hoping on our trades, when we don’t manage our trades with stop-losses.

When you are coming out of drawdown, and you are still making back that lost capital, you still have to manage the trade, and prevent the profits from evaporating. You certainly risk extending the drawdown by not increasing your stops. The tendency in drawdowns is to swing for the fences and make it all back in one or two trades. That is the worst thing you can do. Instead, manage each trade. Take what the market is willing to give you. Don’t impose your needs on the trade.

The market will never care about what you need or what you want. Instead, you have manage the trade. That is all you can do!

Profits are made back by managing future losses

When you neglect to manage each and every one of your trades, you will stay in a perpetual drawdown. Refusing to take a loss on the next trade and demanding your vindication will only assure that you are wrong again and again. There will be losses, you will be wrong on trades, regardless if you are in a drawdown or not. But when those losses happen, keeping them small, and moving on to the next opportunity to profit, will be the only shot you have at making back that capital and increasing the size of your portfolio over time.

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