Tuesday, August 30, 2016

The Three Big Reasons for Trading Drawdowns

Great traders, like great poker players, know when to play and when to fold their cards and wait for something worth betting on.  Too often, the love of trading expresses itself as a need to trade, and the need to trade leads players to play the wrong hands.  Worse yet, the need to trade leads players to sit at the wrong tables.  If you're at the wrong poker table, the hands you draw won't really matter.  

Folding your cards means that you're properly focused on opportunity, but the opportunity isn't present, right here and right now.  Yesterday, I wanted to be a buyer of stocks, but volume was waning through the day.  That tells me that momentum and follow-through on moves will be limited.  I want to buy weakness, not try to ride breakout strength.  If the market is showing me strength and I don't want to chase it, I've got the wrong hand and I'll wait for the pullback to give me better cards.  A great poker player is a patient one.

But let's say that I'm stumble onto a Vegas floor and plop myself down at the first table where I see an opening.  Had I stood by and watched play for a while, I would have recognized that these are experienced sharks waiting for some bait.  Instead, I start playing at the wrong table and become the bait.  That happens in markets when we force our trading style onto markets that are moving a very different way.  If I'm a trend following investor who places bets based on central bank policy and those policies have radically changed from their norm, I'm at the wrong table.  I'm playing the wrong game.

If you're in drawdown mode, it's important to ask if the problem is with your betting versus folding or if the problem is sitting at the wrong table or playing the wrong game altogether.  Are your tactics needing adjustment, or do you need a different strategy?  The most important thing you can do when you're in an unusual drawdown is figure out why you're drawing down.  

There are three big reasons why people have big drawdowns:

1)  They're trading a strategy that doesn't fit the present market;
2)  They're trading the right strategy, but their head isn't in the game and they're not following their strategy;
3)  They're trading the right strategy with a good mindset, but they're employing the wrong tactics and thus not implementing their strategy the right way.

You can't cure a drawdown if you can't come up with the right diagnosis.  Sometimes coming up with that diagnosis means you fold the cards for a while and focus on studying yourself and your trading rather than just studying markets.  Risk management is key because it keeps drawdowns manageable, so that you're sure to have time to learn from them.  The key is folding your cards before you lose your stack.

Further Reading:  Finding Your Trading Strike Zone