Financial markets go through periods of high opportunity when popular strategies book consistent profits, and dry periods when an adverse tape triggers painful or unexpected losses. Traders need to adjust quickly to these drawdowns to protect capital for the next accumulation phase. This inevitably requires a shift away from trading strategies that work for more profitable market periods. (For beginners, see: 4 Common Active Trading Strategies).
This is easier said than done because it’s often hard to recognize the gradual shift into a higher risk environment until sizable losses have already taken a chunk out of the bottom line. Moreover, market players develop an unhealthy sense of invulnerability in easy markets, believing their skills can handle anything the ticker tape throws at them.
This is an illusion because no approach works in all environments and the market’s dynamism ensures that all carefully constructed profit strategies will eventually stop working and lead to repeated losses. Cycle length compounds this inevitability, telling us our trades will go eventually cold, but without saying when it's going to happen.
Meet this challenge with four quick adjustments to your trading plan. (Read: 4 Key Elements To Create A Successful Trading Plan). Apply these techniques as soon as your profits take a dive and the drawdown will end quickly, or at least slow down until you build a new strategy that works in harmony with current condition. Also feel free to apply these concepts any time your profitability hits a wall and you’re not sure what to do next.
Ration The Number of Trades - Most traders forget their discipline during drawdowns and try to "get even" by taking aggressive positions outside the boundaries of their bread and butter strategies. This emotional behavior makes things worse, intensifying losses and undermining confidence. Do it long enough and you may find yourself deeper in red ink than you ever imagined. Get off this dangerous treadmill by setting the number of trades you’ll execute in a single session, and then stick with it. (For related reading, check out: When Fear And Greed Take Over).
Cut Down Position Size – Controlling the number of daily trades won’t slow the drawdown unless you also reduce position size. (See: Effective Risk Control With Scaling Trading Strategies). If things get bad enough, you can even switch to odd lots and play less than 100 shares at a time. This will keep you in the game while reduced risk lets you stand your ground in good positions and feel less miserable when stop-losses get hit. You’ll also find out how much wiggle room you need to give positions and get your performance curve back on track.
Play a Smaller Watch List - Good markets encourage traders to build big watch lists because profitable setups are almost limitless and we don’t want to miss them. The exact opposite is true in adverse markets, where just a few sectors work well while the rest languish or require well-honed short sales. Manage these conditions by cutting the watch list 50% to 80% and tracking just five or ten stocks each day. Don’t take positions in anything else and don’t trade at all if the securities you’re watching don’t offer high reward, low risk opportunities.
Pull The Plug - The last adjustment is the hardest for aggressive traders used to taking sizable risk on a daily basis. Set a dollar threshold for daily gains and losses, with the gain size at least twice the loss size. Get out of the market for the rest of the day when either threshold gets hit. Realistically, this could mean walking away just a few minutes after the market opens and doing something else until the next morning. While the other three changes will underpin your bottom line, this one ensures you’ll bring your drawdown under complete control. (On a related note, see: The Art Of Cutting Your Losses).
Make these four simple adjustments to your trading strategy as soon as drawdowns start to impact your bottom line.