What Kinds of Drawdown Should You Expect?

What Kinds of Drawdown Should You Expect?
The drawdown in your portfolio will typically be correlated to the level of risk exposure of your trading strategy. If your strategy is systematic, you can base future drawdowns on historical maximum drawdowns. If you are a relative value trader, who is looking for a currency pair to rebound after a substantial dip, then you should have an idea of how far you would let your trade move against you before you cut your position. Using historical data to determine theoretical past drawdowns is a great way to gauge maximum drawdowns or drawdowns over a certain period. But always remember, that your worst drawdown is yet to come.
The reward that you experience is predicated on the risk you take. If you are using a trend following trading strategy such as a moving average crossover, you should expect that the strategy will lose more than it wins, and, that you will experience prolonged drawdown, until the market begins to enter a trending phase. 
When you design your trading strategy you need to be cognizant of the types of drawdown you expect to occur, and be willing to accept this drawdown as part of your trading business.

Creating a Drawdown Plan
Unfortunately, drawdowns are part of forex trading.  Potential reward is inextricably linked to risk, meaning Investors will typically generate returns which are predicated on the level of risk they are willing to assume.

The key to managing a drawdown is to have a risk management plan that allows you to survive adverse market conditions. By creating a drawdown plan, you can determine how you will handle your risk if the market moves against you during an unexpected Black Swan type event or during a prolonged losing streak.

You can start this process by determining the maximum loss you are willing to assume before you terminate the trading strategy.  Your risk should be a function of the reward you are attempting to generate. For example, if you are looking to double your portfolio within a year, you might need to accept a risk where you may lose nearly half your portfolio.  Many newbie traders have a hard time understanding this concept and as a result they tend to blow up their accounts using excessive leverage.

You should also consider managing your drawdowns on a monthly basis, as well as, on an annualized basis.  Many trading plans have monthly cut offs, as well as, an annualized maximum drawdown.  For example, if your maximum drawdown for termination is 30%, you might consider a monthly maximum drawdown of 5-6 %.

What’s the Plan if You Reach Your Drawdown Limit?
A natural question you might have is what are you expected to do if you hit your monthly drawdown.  There are several techniques you can perform to mitigate your risk if you hit your monthly stop loss level.  For example, you could completely unwind your risk and flatten your positions.  You could also hedge your exposure with options which allows you to reduce your exposure but remain in your positions.

For example, if you are long EURUSD, you might consider the purchase of a Euro FX put option that expires at the end of the month.  While the premium might take you above the maximum drawdown for the period, you will have reduced any additional losses, but can participate in the upside if EURUSD moves in your favor.  Recall, a put option is the right but not the obligation to sell a security at a specific price on or before a certain date.

One of the benefits of trading the forex market is that most of the currency pairs are liquid and as a trader you can exit a position with little slippage at any point in time. While some currency pairs are more liquid during specific time zones, the majors and crosses always provide some form of liquidity.

If you have a position in an illiquid exotic currency pair, such as an emerging market currency pair, that is difficult to sell, then you might need to consider what type of proxy you can utilize if your losses exceed your maximum drawdown.

Part of your drawdown plan might be to trade a basket of currencies or products that are uncorrelated where you might experience a maximum loss in one security, but the other securities in your portfolio offset those losses.

Prior to trading, you should have an idea of how you will handle your drawdowns.  You should think about how you will handle your risk in specific situations.  Most importantly, if you are trading illiquid assets, determine if you can absorb an outsized loss, if the market moves abruptly in a manner adverse to your position.

Trading Pitfalls
One trading pitfall that novice traders typically engage in, is trading multiple related currency pairs using the same trading strategy.  These can lead to returns that are highly correlated to one another, and while the gains can be exceptional, when the market turns against you, all your positions can lose money at the same time. This is a scenario you want to avoid.

One way to avoid this is to run a correlation analysis on the currency pairs you want to trade in your portfolio to see if they are highly correlated.  If the correlation between the currency pairs are consistently above 80%, you should avoid using these currency pairs to trade the same strategy at the same time.

Summary
You need to understand that drawdowns are a natural part of trading.  You should expect that your portfolio will have drawdowns that are consistent with your trading strategy and risk management.  The maximum drawdown is a very important statistic that describes the peak to valley loss percentage associated with your trading strategy.

Since drawdowns are part of your trading business it is important to create a plan that will handle drawdowns as they occur. You should determine exactly what assets should be liquidated or hedged if the securities in your portfolio experience losses that are beyond the tolerance set for an individual period such as a month, quarter or year.

You should avoid trading highly correlation currency pairs or assets using the same trading strategy as your potential drawdown can be larger than you expect if the performance of your securities decline all at the same time.

By sticking to a drawdown plan, you are more likely to manage and weather drawdowns and live to trade another day