Understanding Drawdowns and Risk of Ruin

Key Takeaways
• Your #1 goal and priority in trading is capital protection. You need to stay in the game. If you
think you can outsmart or figure out the markets and take bigger risks, you will lose your
money. There is no question about that. The markets can stay irrational much longer than you
can stay liquid. In plain terms, the markets can act weird and do things you think are
impossible for them to do, and they can keep doing them far longer than your account size can
handle- no matter how much money you have. Traders of all sizes, from 1 lot traders to multi-
billion dollar hedge funds, have experienced the harsh results of not understanding and truly
believing that.

• There are two broad paths to losing your capital:

o Going through a losing stretch while risking too much of your account per trade
(incorrect position sizing).

o Not cutting losses quickly and thereby ending up with losers that are too large (incorrect
trade management).

• When you hit a losing stretch after reaching an Equity peak in your account, the size of the
losses is called the Drawdown. The low point of the drawdown is called the Equity trough. The
equity curve of a consistently profitable trader will look like an upward trending price chart. It
will have successively higher equity peaks interrupted by regular draw-downs. Losing is a
normal part of trading, even as the profitable trader makes money overall.

• What is considered an acceptable drawdown? This depends on math and also on your personal
psychology. The math shows that the larger your drawdown, the greater the return percentage
you need to make just to get back to break-even. This means that the more you dig yourself
into a whole, the harder it is to get out of it. The psychology aspect of it tells us that if you lose
a large percentage of your account, say 50%, even though mathematically speaking it’s still
possible to recover, practically speaking you will likely become far too emotional and will start
trading based on fear. The result is that your psychology won’t be able to recover and you’ll
likely lose the rest of your money or be forced to quit.

• Given this, you should not accept a drawdown of more than 25% or 30%. It may need to be
much lower than that for your personality, but no matter who you are, this should likely be
your upper limit that you choose.

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