Trading Mindset: Dealing with a Drawdown
One of the most important concepts in trading is that of Drawdown, but very few investors truly understand its meaning. Let’s see what it’s about and how to use it to our advantage when placing stop losses in our strategies.
A drawdown is nothing more than the decrease in capital in our account or position from a peak to a relative minimum.
However, it is best observed from a peak to a minimum and back to a peak (like in the picture above). The reason for this is that a decline cannot be considered complete until it recovers the previous level or surpasses it.
The best way to calculate it is in percentage terms:
Drawdown: (maximum value – minimum value) / maximum value
That is, taking the example of $BTC in 2017, if our maximum value is 20K and our minimum value is 3K, the drawdown was 85% ((20-3) / 20 = 0.85).
While it’s important to know what it is, the relevant aspect is what we do with that information when initiating new trades, as it serves as a precedent for setting a stop loss and not leaving anything to chance.
To do this, we need to know our track record to analyze the numbers.
On one hand, we need to know what our drawdown is at the beginning of a position, that is, the drawdown calculated from the entry point of a trade. On the other hand, we must know the drawdown we usually have when the trade moves in our favor and then declines (this would be the concept described in the formula above).
So, with this data, we need to obtain the average drawdown and the maximum drawdown when entering a position. With this in mind, we have a reliable figure of how much % space we should leave to accommodate the asset’s volatility (here it is important to segment the study as it is not the same for a stock as for a cryptocurrency).
For example, if our average DD is 10% and our maximum DD is 15%, we have a clear level to place a SL (stop loss). Here, the size of the position will greatly influence whether we position it slightly below the average or beyond the maximum.
And then, assuming the trade moves in our favor, knowing the average and maximum DD allows us to know how much space to give to the SL or trailing stop. This allows us to move the SL as the price advances, reducing the risk of the operation and ensuring partial profits.
Using DD as a way to set a SL is a good method but it should be combined with other tools for even better results such as supports, trend lines, Fibonacci levels, Elliott waves, etc.
