The Easy Way to Minimize Drawdowns

by Darrin Donnelly on July 11, 2012

Drawdowns are the necessary evil of trading.  Nobody likes to have drawdowns, but they’re an unavoidable part of the trading game.

For those unfamiliar, a “drawdown” is the decline your portfolio experiences from its peak.  If a portfolio reaches $100,000 and then pulls back to $80,000, it has experienced a 20% drawdown.

Usually, but not always, the bigger the annual return you aim for means that you must be prepared to withstand a bigger drawdown.  It’s not at all uncommon for some of the best trend traders in the world, traders with streaks of 100%-plus annual returns, to experience drawdowns of 50% or more.

Drawdowns are caused by two factors.  The first factor is a streak of losing trades.  For the trend trader, losing-streak-induced drawdowns are usually not too severe.  This is because trend traders like to EASE into positions that have just broken out and because they keep tight stops to minimize the damage caused by a trade that goes against them.

A professional trend trader is likely to initially risk no more than 1% of his portfolio on a new breakout.  It would take a streak of 10-straight losing trades to create a drawdown of just 10%.  A drawdown in the range of 10%-20% is quite manageable.

The second major cause of drawdowns is when a large winning position reverses and breaks its trend.  This factor is much more significant for trend traders.  

The key to successful trend trading is riding a trend until it breaks.  Usually, once a stock has broken out, a trend trader will add to his position as the stock climbs.  By the time the stock is up, say, 50% or more, a trend trader who got in at the initial breakout is HEAVILY invested in the stock.

Of course, all great trends eventually come to an end, and this is where a trend trader experiences significant drawdowns.

While a trader may have been up 100% year-to-date thanks to a powerful trend he caught, a drawdown of 20%, 30%, or more can come along very quickly.  The fully-leveraged trend trader can easily watch his portfolio go from up 100% to up 50% in less than a month.

The “glass half-full” perspective can remind the trader that he’s still up 50% from where he started.  But no trader I know takes comfort in that perspective.  Instead, they feel the pain of a 50% drawdown.

How can a trader minimize the pain of these types of drawdowns?

The simplest way I know is something called “reverse pyramiding.”

Standard “pyramiding” means adding to a position as it shows strength.

For example, a trader may initiate half of their intended position on the breakout, then add another quarter position once the stock breaks through a second resistance area, and then add the final quarter position when the stock bounces back from a pullback, etc.

“Reverse pyramiding” means unwinding a position as it pulls back after a massive run.

For example, if a trader catches a trend and becomes fully-invested in that trend, he should start easing out of the position when the stock starts pulling back.

Reverse pyramiding can be applied to your whole portfolio.

Here’s an example.

If your portfolio drops 5% from its peak, immediately scale back 25%.  That is, if your portfolio reached a peak of $100,000 and then pulled back to $95,000, you’d want to eliminate one quarter of your holdings.

You can eliminate these holdings by cutting each of your positions down by 25% or you can cut back larger amounts from the stocks that are struggling the most.  I recommend the latter, but either option will immediately limit the drawdown your portfolio may be on the verge of.

You would continue with this “reverse pyramiding” process with each 5% drop from your portfolio’s peak.  If it drops to $90,000, you want to cut another quarter of your holdings.  If it hits $85,000, cut another quarter.  If it hits $80,000, you’d eliminate the final quarter and a 20% drawdown is the MOST you’d experience.

The nice thing about this method is that with each quarter of your holdings you cut, it gets harder for your portfolio to drop significantly (because you now have smaller positions).  In other words, this strategy makes it very difficult to actually hit a 20% drawdown because most of your positions would have already been exited.

Pyramiding, in either direction, is a powerful trading tool.  Learn to use it effectively.  It’s a simple way to maximize your profit potential and minimize your drawdowns.

 

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