Managing Risk in a Drawdown

By David Hobart
22 September 2009

Having drawdowns is part of the trading business. They are rarely pleasant, but with the right risk management approach, they can be experienced without unnecessary discomfort.

There are many different schools of thought about how to manage risk for different strategies. Regardless of your strategy, it is important to define a context for risk management that works in line with your personality type. The context I use is that my risk management rules are there to protect me. Given that I am generally risk averse by nature, I need to be able to focus on making money, rather than worrying about losing it. By having the right risk rules, I am free to trade without fear.

Conversely, if I were more naturally a risk taker, I would have rules that help me to be more risk focused and aware, thereby limiting the depth of any drawdowns.

Define your Line

All trading strategies should have a line in the sand which defines the maximum tolerance for a drawdown. This line defines the risk of ruin and consequently needs to be defended at all costs. By defining it in your strategy, you are declaring your commitment to protecting your trading capital. This commitment is critical in managing risk well.

In my strategy, I have a 25% peak-to-trough drawdown rule, which if breached, would result in a conversation with my investors and a potential closure of the Fund. This rule forms the foundation on which all other risk rules are built. From here however, different risk methodologies are suited to different strategies.

Discretionary vs Systematic

Running a discretionary strategy, I manage my risk by reducing the incremental capital at risk per trade as I move into drawdown. Firstly, I define risk capital as 25% of total funds under management at my peak performance high water mark. I then calculate my risk per trade as a percentage of this risk capital. This means that as I go into drawdown, the capital I risk on each trade reduces quite quickly, limiting the depth of any drawdown. This strategy is particularly helpful for discretionary strategies given that past drawdowns are not necessarily indicative of future ones.

In a systematic process, the entry and exit methodology can be more accurately measured and back tested. If your testing methodology is valid, it is typically easier to pre-define per trade risk as you have a sound statistical basis for estimating the depth of future drawdowns.

Regardless of whether your strategy is discretionary or systematic, having the right risk methodology will allow you to trade without fear, even when you are experiencing a period of losses.

Until next time, I hope you enjoy your trading journey.

Market Insights

Each month, I publish my thoughts and current market exposures in the Apeiron Global Macro Fund’s monthly performance reports. These can be accessed via http://www.apeiron.com.au/reports.html .

If you would like to find out more about David Hobart’s trading coaching and mentoring programs, please email David at dhobart@traderemotions.com.au .  

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Disclaimer: The contents of www.traderemotions.com.au is general information only and in no way provides advice in a personal or general nature. David Hobart and his related entities can not be held responsible for any loss, cost or expense resulting from your activities related to the subject matter in this document and or relating to www.traderemotions.com.au

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