• : February 7, 2021
• : B. Krishnakumar

Losses, Mistakes & Drawdown

This week, I wanted to discuss about an important and often neglected concept which sort of ties-in with the psychology concept discussed last week. Before we dig deep, let us understand some basic concepts which will make this post more impactful.

We begin with the equity curve concept. Simply put, the equity curve is your total capital on any given day. You can plot the equity capital as a line chart. This chart will go up after a profitable trade and will drop after a losing trade.

If you have a series of winning trades, your capital will obviously increase, or it will be in an uptrend. Similarly a string of losing trades will erode your capital and the equity curve will start sloping downwards. Have a look at the data and chart displayed below.

The above graphic captures hypothetical data to illustrate the concept. The assumption here is that we start with an initial capital of Rs.1,00,000 and take 10 trades using our system. The outcome of each trade is mentioned in the table and the total capital after each trade is also recorded.

This total capital is plotted as a chart on the right-hand side. The equity capital makes a high after 4 winning trades and then drops because of a series of losing trades. The capital drops from the peak it recorded and then recovers to make a new high.

Drawdown is nothing but the lowest point between two equity highs.

It takes time and effort to recover from the drawdown and make new highs in equity curve. In the above example, there was a drawdown of Rs.7,000 or 6.1% from the peak of Rs.1,13,500. Typically, it better to study drawdown in percentage terms to get a better idea of performance. But in this example, I have used actual capital for ease of understanding.

What Causes Drawdown?

The answer is straight forward. It is the losses which cause drawdowns. And most of the time, the equity curve will be in a drawdown because every losing trade will either result in a drawdown or push the equity curve deeper into the drawdown cycle.

It is apparent that losing trades trigger drawdown. And losing trades are unavoidable because there is no system in this world which has 100%-win ratio. If your win-ratio is not 100% then losing trades WILL happen and it will trigger drawdowns.

The message here is that losing trades and drawdowns are unavoidable.

Let us dissect losing trades a little further. Losing trades can be triggered by following our system, which is unavoidable. But losing trades can also be triggered by our mistakes. By mistakes, I mean losses triggered by not following our rules or trading system.

Apart from normal losses and mistakes, there can be an unknown factor that can trigger losses which is popularly known as black-swan events. Such events are unpredictable, but we can budget for such events through our money management module. But more about this later. And such events are not under our control.

Once the equity curve gets into a drawdown, it takes time and remember that we are working with a depleted capital to recoup and progress. Have a look at this table. If you understand this table, it will make a world of difference to your trading personality.

The above table captures the percentage losses and the subsequent percentage gain that is required to recover those losses. Assuming your equity curve makes a high of Rs.100. If there is a subsequent drawdown of 5%, then your equity capital depletes to Rs.95. To get back to the equity curve high, you will have to generate profit of 5.3% using the depleted capital of Rs.95. This will take you back to your prior equity curve high.

Suppose if there is a drawdown of 20% from the equity curve high of Rs.100, then your capital reduces to Rs.80. You will have to generate returns of 25% on the depleted capital of Rs.80 which will help you get back to the starting point or the equity curve high of Rs.100.

It should be apparent that the bigger the drawdown or loss, the more difficult it gets to recover.

If the drawdown is triggered by following system rules, it is a normal loss, and we cannot avoid it. But if the losses are triggered by our mistakes then it is criminal. Remember, every mistake and the subsequent loss is setting us back in the above table. The more such mistakes you commit, the bigger the loss and tougher it gets to recover from the drawdown.

it would prevent you from making those mistakes.

Before we wind up, remember, the extent of drawdown and the recovery time depends on the position sizing, risk-reward, and win-ratio of your system.

Hope this helps!!