Farley: Don't Sweat a Drawdown, Learn From It

This wakeup call has two common outcomes. First, it forces marginal traders to wash out of the markets and move on to safer hobbies. Second, it motivates serious-minded traders to discover how the markets really work and what it takes to survive in all types of environments, good and bad.

Identify your "fail-safe" drawdown level early in your career. This is the maximum amount you're willing to lose before turning off your screen and walking away from the market. This hiatus need not be permanent. It's just a recognition that things have gone wrong and a period of self-analysis is needed before taking on new risks.

This vacation from the market lets traders examine personal issues that may be hidden in the heat of day-to-day battle. It also allows them to get to bedtime without fresh losses weighing on their minds. This simple abstinence often ends the drawdown cycle and fosters instant success when they finally return to the action.

The pain of a drawdown period will turn you into a more profitable trader if you listen closely and adapt quickly to its embedded messages. But the same pain can destroy your ambitions and capital if you choose to ignore the experience. It's really up to you: Do you want to fight the market, or do you want to make money?

The key difference between good traders and bad ones is how they turn their drawdowns into acts of personal power. We're all shocked to discover we're just mortals when the tables turn and we start to take big losses. But the experience exposes us to the truth serum we need to survive and prosper in the long term.

This was originally published on RealMoney on August 14, 2008. For more information about subscribing to RealMoney, please click here.