How I Avoided Large Drawdowns
Factors that triggers massive losses and how to avoid them
The only form of trading I indulge in is trend following. I do not believe in tightness on the chart. No buying the smaller momentum. Definitely not the momentum bursts. For me, a trend means big trends. I am not interested in smaller trends that last only a few days. Sure, one can buy with a high position size and get the same effect. But I’d need too many trades to achieve good performance. I don’t mind leverage. But the story involving leverage doesn’t end well, so I usually avoid it.
With big trends, I get the freedom to take fewer trades. The higher magnitude of profit means I get bigger moves. Less trade management. Similar portfolio impact. In bad markets, I get fewer stocks. In good markets, I get bigger moves more frequently. I can manage my writing, my job, and my family time by taking fewer trades. It’s this same behavior that helped save me from huge drawdowns.
High drawdowns mean either too many bad trades or fewer bad trades with bigger risks. Bigger risks can arise from wider stop losses, high position sizes, or the use of leverage. I don’t take leverage. Maybe in the future, I will dedicate a small amount and use leverage. But for now, there’s none. I take 1% account risk on every trade. I take about 30–35 trades a year. In a good market, I take 20–25 trades because most of them tend to perform well.
This significantly reduces my potential for high drawdowns. Some might argue it also reduces the potential for super performance. I hardly care about that. I’m aiming for consistency. The magnitude of profits in a good market takes care of performance. The stability during bad times takes care of longevity. I am young. I have enough time to generate massive returns. So, I’m not looking to tweak just for the sake of it.
In 2022, I stopped trading derivatives with dedicated capital. I allocated most of my capital to equity. I decided to use derivatives only as a hedging tool. So, I invested 15% of my capital into derivatives. When markets were going down and stocks were hitting stop losses, derivative returns were good. Low drawdowns from stocks, coupled with high returns from derivatives, meant I didn’t have to face the full wrath of a bad market.
I don’t want to promote derivative trading. I want to promote reduced trading. Your first job is to reduce the constant trading. This will naturally lower your probability of facing a series of losses. Too many trades increase the probability of too many losses. That leads to higher drawdowns. Higher drawdowns lead to desperate decisions. Stupid decisions.
If you think the market isn’t conducive to your trading style, cut down the leverage. Use the 20 EMA as a filter for leverage. If the market is trading above the 20 EMA on the daily or weekly, use leverage. Otherwise, reduce position size. Definitely cut down leverage. Build a systematic derivative strategy if you can afford it. A strategy tested on 10 years of data, including Monte Carlo simulation, is a good one to have in your arsenal.
Trade management techniques can be employed, but there’s too much subjectivity involved. Exiting in strength is better in theory than in execution. Everybody has a different version of “strength” in their mind. For some, when a stock moves 20% in their favor, they offload the position. For others, even a 10% move triggers an exit. This creates unusual impulses that push people to exit at the first move.
I do not like impulsive trading. I don’t care if a stock moves 20% on the first day. Anything that requires me to jump to my trading terminal isn’t good for me. So, I keep it simple. When the stock moves in my favor, I look for the next logical stop loss. And then I don’t look at the chart—at least not until it hits my stop. That’s the only way to control impulsive behavior.
You can only manage drawdown if you size your trades appropriately. You must find ways to trade at least two out of the three market phases. Covered Calls are a time-tested strategy, but they aren’t worth it for regular traders. Too much hassle. One bad month can affect your portfolio returns. For a swing trader:
Size the trade properly
Use leverage judiciously
Reduce the frequency of trades
Improve the magnitude of profits occasionally
I’m thinking of exploring my best and worst derivative trades in the newsletter. Do let me know what you think. If you want, I can dedicate a newsletter edition to discussing the typical stock moves that I trade—my best and worst trades. If it works well, maybe we can dedicate a day each week for such newsletters.