The Question to Ask When You're in Drawdown

If you're losing money in your trading, there is an important question that can help you figure out your next steps.  This is important, because sometimes traders become so interested in stopping their losses that they don't first figure out what is causing them.  They look to psychology for answers, when it's their trading strategy that is flawed.  They hop from trading approach to trading approach, never addressing the psychological issues that are sabotaging whatever they're doing.  If you're losing money, something has to change, but how do you figure out what that something is?

The question that helps sort out promising directions for those in drawdown is this: 

Are other people, trading similar strategies, also losing money?

That will tell you quite a bit.  If you were making money and suddenly go cold and others in the same markets, with similar strategies are doing the same, then you know that it isn't simply a psychological issue.  Everyone did not suddenly lose discipline or become an idiot at the same time.  Rather, the strategy is not working under current market conditions, or it has stopped working altogether.

If the strategy has stopped working under current conditions (as, perhaps, in the case of a breakout strategy in stocks failing to make money in conditions of low volume and volatility), then the answer is to pull back risk-taking and go into research-and-development phase.  Your goal is to find strategies that can supplement your existing ones and make money in the challenging environment.  For example, you might add a "value" strategy that sells overbought conditions and buys oversold ones to the breakout strategy.  The combination of the relatively uncorrelated strategies would potentially give you a smoother profit curve, allowing you to make money across regimes.

Only over time will you be able to identify if the strategy has stopped working altogether.  If, in conditions in which you (and others with similar strategies) have made money in the past, you (and others) remain unable to prosper, a plausible hypothesis is that a more fundamental shift has occurred in markets.  You're like the company that has made money selling laptops, only now to find out that the demand is for tablets.  The market has changed.  That's why the research-and-development efforts and pulling back of risk-taking are so important when you (and others) lose money:  we never know initially whether drawdowns are temporary or reflect structural market changes.

On the other hand, if you're losing money and others are succeeding with similar strategies, then you have real evidence that the drawdowns are more about you than about the market per se.  Perhaps your implementation of the strategies needs work; perhaps your psychology is undercutting your implementation; perhaps your analysis that feeds the strategies needs supplementation.  All of those can be fruitful directions for exploration.  It's often the case that, when psychology is the culprit, you'll fail to make money when your peers in similar strategies are prospering.  Keeping a psychological journal--what's happening in markets, whether you're making or losing money in trades, your frame of mind during the day, etc--can help you identify patterns underlying your successes and your drawdowns.

Intelligence begins with asking the right questions.  Is it me, or is it markets?  We are most likely to find the cure to our trading ills if we first make the right diagnosis.

Further Reading:  Why Psychology is Central to Trading
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