Trader Mindset

The duration of your drawdown is "how long" it takes you to get back to the previous high. It's one thing to be down 10%, but how long will it take you to recover?

If your losses are "in model" there's no reason to panic. You can get this information from backtesting your rules in a simulator. If you are trying to read charts, you're out of luck because your activity is based upon guesswork. 

While you're enduring a drawdown, your instincts might lead you to begin trading more frequently. 

Greater frequency of trades doest not equal greater opportunity. Most trades are suboptimal so I think you'll do better in any case by trading less.

Your instincts might also lead you to "investigate" a new trading methodology to "overlay" on your existing rules, such as option selling because it brings in "revenue." You can lose your a** selling options. 

Behave consistently as you would when you're up 20%. All you do is follow your rules. Take it one day at a time. 

Meditate on how you feel when you have to be patient. You might feel anxious, depressed, angry, and frustrated to name a few. I don't believe your can overtrade your way out of a drawdown. 

You may also consider trading a larger position on something that you are "sure of" because "...if it only goes up 10%, I'll be back to even." 

"To every thing there is a season, and a time to every purpose under the heaven" - King James Bible

Your trading rules might be "out of season" with the market. If you're a commodity trader, you know those markets are cyclical - so no surprise there. If you're an equity trader, sectors rotate so your winners will ebb and flow in secular markets. 

You will go much further as a trader if you understand that losing money and drawdowns are not a reflection of your ability to create alpha as a trader. But how you handle losses and drawdowns emotionally and behaviorally will provide you and others insight on your managing larger sums of money. Investors and allocators need to know you can be trusted.  

If you want to be a professional trader, losses are part of the business. How you deal with losses, collectively called drawdowns, differentiate the amateurs from professional behavior.

If you're down 20%, you need to do 25% to get back to even. This is important because you don't participate in the upside, ie, absolute performance, until you actually make the client money.

Your sharing in the profits are called Incentive Fees or Profit Allocations and they are benchmarked against the initial account balance, aka, the "high water mark."

Your ability is going to be measured by performance or alpha, but also how little you lose. Risk adjusted returns therefore are your goal. If you can garner market-like returns but with only a fraction of the drawdown, you'll be able to differentiate yourself from the competition.

[Remember, the riches go to the salespeople. You need to learn how to ask people for money. It won't typically show up just because you have great risk adjusted returns. You need marketing and sales to 'show and tell' your performance.]

Shorter time frame trading does NOT give you more control over your losses or drawdowns. It just means that you're likely to "die by 1,000 cuts" instead of taking a position and hold the risk over night and over the weekend. Those are good risks to take. Selling or offsetting your trades because it's the end of the day is known as "bad risk" - full of giant opportunity cost. In effect, you're leaving money on the table by not taking trades home.

In order to minimize the impact on your P&L and also on your emotional constitution, you can take a haircut on your equity when you're in a drawdown. If you get to 80% of a previous high water mark, you can trade based upon 60% of your remaining equity, and effectively trade 48% of your original capital. This helps you trade smaller when your system is not aligned with what the market is doing. Your bet sizes will be based upon a smaller capital base.

Set a max drawdown limit for the day, week, and month to keep your losses in order. Examples can be "never lose more than 1.00% of your overall equity in one day," or "stop trading at -9.50% for the month" thereby avoiding a double-digit down month.

This infers that if you're at -9.50% on the 20th of the month, you stop trading until the start of the next calendar month. This may seem counter-emotional to you when I've told you to stick to your system, but you can benefit greatly as a professional trader/PM if you can say that "you've never had a down month of 10% or more." This rule is a circuit breaker in your system.

Talk to prospective clients about how they deal with losses. If you show them that you have a superior methodology for dealing with losses than the other managers they're dealing with, there is an opportunity for you to capture those assets under management.

If you want to be a professional trader, losses are part of the business. How you deal with losses, collectively called drawdowns, differentiate the amateurs from professional behavior.

If you're down 20%, you need to do 25% to get back to even. This is important because you don't participate in the upside, ie, absolute performance, until you actually make the client money. 

Your sharing in the profits are called Incentive Fees or Profit Allocations and they are benchmarked against the initial account balance, aka, the "high water mark."

Your ability is going to be measured by performance or alpha, but also how little you lose. Risk adjusted returns therefore are your goal. If you can garner market-like returns but with only a fraction of the drawdown, you'll be able to differentiate yourself from the competition.

[Remember, the riches go to the salespeople. You need to learn how to ask people for money. It won't typically show up just because you have great risk adjusted returns. You need marketing and sales to 'show and tell' your performance.]

Shorter time frame trading does NOT give you more control over your losses or drawdowns. It just means that you're likely to "die by 1,000 cuts" instead of taking a position and hold the risk over night and over the weekend. Those are good risks to take. Selling or offsetting your trades because it's the end of the day is known as "bad risk" - full of giant opportunity cost. In effect, you're leaving money on the table by not taking trades home.

In order to minimize the impact on your P&L and also on your emotional constitution, you can take a haircut on your equity when you're in a drawdown. If you get to 80% of a previous high water mark, you can trade based upon 60% of your remaining equity, and effectively trade 48% of your original capital. This helps you trade smaller when your system is not aligned with what the market is doing. Your bet sizes will be based upon a smaller capital base. 

Set a max drawdown limit for the day, week, and month to keep your losses in order. Examples can be "never lose more than 1.00% of your overall equity in one day," or "stop trading at -9.50% for the month" thereby avoiding a double-digit down month.

This infers that if you're at -9.50% on the 20th of the month, you stop trading until the start of the next calendar month. This may seem counter-emotional to you when I've told you to stick to your system, but you can benefit greatly as a professional trader/PM if you can say that "you've never had a down month of 10% or more." This rule is a circuit breaker in your system.

Talk to prospective clients about how they deal with losses. If you show them that you have a superior methodology for dealing with losses than the other managers they're dealing with, there is an opportunity for you to capture those assets under management. 

Gains look like gains only to the extent that you keep your losses small.

Most traders lose and quit the business in frustration because they are underfunded, focused on short-term time frames, and trade to large for their capital space.

You can gear your target RoR for a high number, like 100%, but you'll also have to endure a drawdown of 40-60%.

I'd focus on consistency in your approach and your discipline. That is what you bring to the table that amateurs cannot. If the average person could act consistently around managing risk, there'd be no need for portfolio managers.

Risk-adjusted returns are the key to getting an allocation. Sure you can get big returns, but at what risk to the operation? Anyone can roll the dice and hit it big once or twice, but that's not how to build a business. Those type of results appear from random luck, not a bankable process that can be repeated like a robust trading system that can be deployed across many markets.

This podcast episode was inspired by a great email that I got about one particular trader's performance and a few of his discussions with "prop trading desk managers" (read: brokerage).

There aren't many prop trading firms out there. Most are brokerage masquerading as prop trading. True prop trading is a firm that will give you funds to manage WITHOUT your needing to deposit your own funds because you are talented.

If you want to trade your own capital, wait 6-12 months and see if you've developed a sense of trust with the firm. Making a deposit to an account makes you a brokerage firm client, not a prop trader.

Gains look like gains only to the extent that you keep your losses small. 

Most traders lose and quit the business in frustration because they are underfunded, focused on short-term time frames, and trade to large for their capital space.

You can gear your target RoR for a high number, like 100%, but you'll also have to endure a drawdown of 40-60%. 

I'd focus on consistency in your approach and your discipline. That is what you bring to the table that amateurs cannot. If the average person could act consistently around managing risk, there'd be no need for portfolio managers. 

Risk-adjusted returns are the key to getting an allocation. Sure you can get big returns, but at what risk to the operation? Anyone can roll the dice and hit it big once or twice, but that's not how to build a business. Those type of results appear from random luck, not a bankable process that can be repeated like a robust trading system that can be deployed across many markets. 

This podcast episode was inspired by a great email that I got about one particular trader's performance and a few of his discussions with "prop trading desk managers" (read: brokerage).

There aren't many prop trading firms out there. Most are brokerage masquerading as prop trading. True prop trading is a firm that will give you funds to manage WITHOUT your needing to deposit your own funds because you are talented. 

If you want to trade your own capital, wait 6-12 months and see if you've developed a sense of trust with the firm. Making a deposit to an account makes you a brokerage firm client, not a prop trader. 

We make predictions all the time, so why not in your trading?

Professional traders will backtest and then add new elements or parameters to their existing system(s).

Markets will evolve also, so you need to keep pace with evolving market environments. That means experimentation with something new.

You can also test your hunches within the discretionary percentage of your trading. For example, some traders are 90% systematic and 10% discretionary.

Test your predictions and hunches in the 10% discretionary allocation. Just make sure to follow you risk controls, ie, max risk per trade and correlation studies before you put on the trade.

I think prediction gets a bad rap because anyone who doesn't have a system is effectively guessing at the market. That typically doesn't work out that well for too long until your rules get systematized. For one, you need to have rigid risk management techniques in place.

It's likely that you will blow up if you put a large percentage of your capital on any one idea based upon a prediction or hunch. Risk 0.50% instead of 50%.

Your feelings aren't facts and it's better to gauge your reasoning with proper risk management. There will always be new ideas to trade, but if you roll the dice on one name based upon a prediction, with no training, you're likely to get the worst of it.

We make predictions all the time, so why not in your trading?

Professional traders will backtest and then add new elements or parameters to their existing system(s). 

Markets will evolve also, so you need to keep pace with evolving market environments. That means experimentation with something new. 

You can also test your hunches within the discretionary percentage of your trading. For example, some traders are 90% systematic and 10% discretionary.

Test your predictions and hunches in the 10% discretionary allocation. Just make sure to follow you risk controls, ie, max risk per trade and correlation studies before you put on the trade. 

I think prediction gets a bad rap because anyone who doesn't have a system is effectively guessing at the market. That typically doesn't work out that well for too long until your rules get systematized. For one, you need to have rigid risk management techniques in place. 

It's likely that you will blow up if you put a large percentage of your capital on any one idea based upon a prediction or hunch. Risk 0.50% instead of 50%.

Your feelings aren't facts and it's better to gauge your reasoning with proper risk management. There will always be new ideas to trade, but if you roll the dice on one name based upon a prediction, with no training, you're likely to get the worst of it.

Many of our students set goals based upon what they want the end result to be. Hard to have ownership of going from point A to point B if you don't know how to get there.

Typical goals could be delineated accordingly: "I want to gain 15 lbs of muscle," "I want to lose 10 lbs of gut fat" or "I want to earn $X or X% this year."

Instead, focus on what you have to do to get those results.

For example, replace "I want to gain 15 lbs of muscle," say "I am going to the gym at 5 am M-T-Th-F each week before I get to the office."

Then you can break down what exercises you'll do each day to breakup the workout so you don't go nuts, but also so you'll have much more ownership about the process. You can envision going to the gym and the exercises you'll be doing more than what you'll look like having lost the weight or adding 15 lbs of muscle.

Professional traders focus on process, not results, so this type of thinking is in line with best practices.

We find that when our clients or students focus on the the process of what they're endeavoring, they get better results, perform more consistently, and enjoy the process of achieving their goals.

You can also make the small adjustments that you might need to make after several weeks, like adding an additional day of rest or adding cardio.

Many of our students set goals based upon what they want the end result to be. Hard to have ownership of going from point A to point B if you don't know how to get there.

Typical goals could be delineated accordingly: "I want to gain 15 lbs of muscle," "I want to lose 10 lbs of gut fat" or "I want to earn $X or X% this year."

Instead, focus on what you have to do to get those results.

For example, replace "I want to gain 15 lbs of muscle," say "I am going to the gym at 5 am M-T-Th-F each week before I get to the office."

Then you can break down what exercises you'll do each day to breakup the workout so you don't go nuts, but also so you'll have much more ownership about the process. You can envision going to the gym and the exercises you'll be doing more than what you'll look like having lost the weight or adding 15 lbs of muscle. 

Professional traders focus on process, not results, so this type of thinking is in line with best practices. 

We find that when our clients or students focus on the the process of what they're endeavoring, they get better results, perform more consistently, and enjoy the process of achieving their goals.

You can also make the small adjustments that you might need to make after several weeks, like adding an additional day of rest or adding cardio.

Frustration is the antithesis of confidence and euphoria. It can cripple you and distract you from your sense of persistence and determination.

Unlike other teachers, I don't put a negative connotation on euphoria - as long as you don't abandon your trading rules, have at it.

You can avoid frustration in the first place by "not" having expectations of the outcomes of anything (or any trades).

This is not the same thing as Expected Value, but an emotional expectation about the result of something you're endeavoring - such as trading.

One sure-fire way to decrease frustration in your trading is to make sure that you're protective stop is not placed inside the 20-day ATR of the instrument that you're trading.

For example, say you're trading an instrument that has a 20-day ATR of 15 points. If you're long and the current market value is 535 and you've placed your stop at 530 because you have set 5 points as your max loss point, you are more than likely to get stopped given that you're stop is well within the ATR. Many times, traders with smaller accounts do just this because they don't want bigger losses. This is respectable and totally understandable.

In our coaching and teaching, we've found that traders disregard the daily vol of the instrument their trading as if it was going to change because the trader put a trade on.

We can't change the nature of things. The instrument that you're trading isn't going to change how it behaves just because you're in the trade.

In the above example, you can trade a smaller position and give your smaller position a greater latitude by placing your protective stop at 520 (535-15). You can test this strategy. You might find that you are not getting knocked out of as many such trades and, if you are trading in strong trends, take the risk home overnight and let the market forces, time, and leverage work for you.