Drawdowns and Emotional Capital

Drawdowns & Emotional Capital

By far one of the hardest aspects of trading is going through a losing period known as a draw down. Not only do you experience a loss of trading capital but it can also cause an exhaustion of emotional capital.

We can't control the markets and the outcomes of our trades, but we can try and reduce the impact of our emotions by adhering to a plan that suits our personality.

After trading for a few years, I realised I found it very difficult (and not to mention exhausting) to follow particular trend following strategies. This often led to draw downs that would leave me questioning the strategy and my thought process. It wasn't until one day where I really broke down the thought process and realised that I needed to trade in a way to protect my mindset by being confident in my strategy. This would allow me to keep a calm mindset when the inevitable pull back came.

Emotional Capital 

Understanding your strategy, statistics, and emotions will aid in protecting your emotional capital which will make the draw down phase less exhausting.

1) Its important to understand your strategy, your setups and what resonates with your personality. Conditions are constantly changing and your particularly strategy will eventually go out of sync with what's working in the market. For example, if your strategy thrives on high volatility and suddenly we enter a phase of trading with low volatility for an extended period of time, your strategy may begin to falter and you will most likely enter a draw down period. If you had no idea about how your strategy made money, you would really start to question yourself and once this occurs, you enter a dangerous proposition whereby it is easy to lose money. However, if you understood how your strategy delivers returns, you would become aware that you may be entering a market environment which is not conducive to your strategy and thereby begin to protect your emotional capital by being more selective or reducing risk.

Understanding your strategy allows you to determine why you are suffering a draw down and how to remain confident in your strategy.


 2) It's important to know your average statistics. If you have a win rate of 40% and over a period of trades this gets below 35%, your strategy is telling you that your style is out of sync with the market and can be a signal to scale back your activity. This doesn't mean you should stop trading altogether, it may just mean you need to be more selective during the current market environment.

Not only do your long term statistics give you an indication of what you can expect from the outcome per trade, but they also set you with a goal. Knowing your win/loss percentage and profit/loss per trade gives you a chance to outperform your current statistics. When you enter a trade you should be thinking, will this trade provide me with a good chance of outperforming my average gain or crystallising a loss smaller than my average loser.


3) Emotions are a massive part of trading and it is easy to get caught up in the roller coaster. If you ever find yourself checking your positions more than usual including looking up message boards, research sites, thinking about the monetary returns DURING the trade - you are on a slippery slope. The key is to remain in control of the trade and in turn, your emotional capital. Write out your plan before the trade (outside of market hours) and let the market do the rest. Stay in control of your trades at all costs. This will keep you in a positive frame of mind that will ensure you don't deviate away from your strategy.