The Brutal Reality of Drawdowns

How much of a licking can you take, when there's real money at stake?
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Way back on Oct. 13,

we met my good friends Rich and Peter. Both are competent traders, but as we found out, Rich had a significant edge over Peter.

Peter, though, was not used to being the second best at anything. No, he vowed to change his method to be at least the equal of Rich. In fact, if all went well, he'd be better.

But before he got too far along in changing his style, Rich suggested to Peter they see my recent presentation in Dallas. Peter wasn't sure he could stand any more swimming references, but Rich assured him he might pick up one or two good ideas to improve his trading.

The following, then, are some excerpts from my Dallas roadshow. It's not a script, per se, but certainly the essence of what I tried to convey to the audience.

I want to touch on a theme I've been exploring lately, a theme I've been paying more and more attention to and trying to highlight, as I think it is one of the most critical areas to focus on if you're going to be successful at trading or investing.

And that theme is drawdowns.

I know, you're already lost. Therefore, let me clarify. If you think of your equity curve as a line chart, you hope it steadily moves up as it moves to the right.

Ideally, in fact, it would move in a perfect line, never dipping for even a day. If that was the case, then this discussion would be moot: You wouldn't have any drawdowns.

But that's not the way it works, is it? No, even if your trading is battle-hardened and razor sharp, you will have down days. You will have off days. There will be days, by golly, where you lose money! In fact, depending on your method or style, there might be weeks or even months where your account goes red.

And this dip, this equity decrease if you will, is called drawdown. It's not fun and it's not pretty, but it's important that you get your arms around it.

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As an example, let's say you started 1999 with $100,000 of equity. But you're smart. And you're conservative, because you decide to paper-trade for one full year before committing any real money.

So, off you go, your method is a winner, and come 10/1/99, you're sitting on $150,000 of equity. "Wow," you think. You just can't wait to start playing with real money!

But, then the market tanks and your longs go belly-up. Sure, you have a few short positions, and they stabilize your ship somewhat. Still, at the end of October, you look at your equity balance, and find yourself not at $150,000, but all the way back to $105,000!

My God, you just took at $45,000 haircut, or in percentage terms, a 30% shellacking. Or in my terms, you just had a pleasant 30% drawdown.

But, heck it's on paper, so you continue the year without missing a beat, have a fine November and December and wind up the year with a sizzling $175,000.

So, you look over your results and think, "Man, a 75% return. That October was brutal, but still, the year ended up being a winner. A big winner! I really have something solid here."

So, on Jan. 1, 2000, you start trading with real money. And amazingly enough, the year unfolds exactly like it did in 1999. Terrific through September, brutal through October and then a fantastic final two months.

It all sounds splendid, doesn't it? Well, here's the rub. I'm betting you never made it to November and December. No, the sad fact is, that 30% drawdown looked like a piece of cake on paper. And it looked especially easy to handle, knowing you made it all back up, and more, by the end of year.

But, in reality, you just couldn't stand the pain. Day after day. Week after week of violent down drafts and steady drips. Watching your equity get drained by $2,000 or $3,000 a day,

day after day

. Why, that was just too much for you to endure.

Or, to paraphrase Jack Nicholson in

A Few Good Men

, you can't handle the drawdown!

And that, in a nutshell, is the bane of all traders and all methodologies. Look, I can come up with wonderful ways to trade that net me well over 100% a year. But I don't employ them because when I run the numbers, I see one or two months where my equity dips 20% or 25%. Not a lot, right? Well, if I'm sitting on $500,000 of equity, I am 100% certain I could not tolerate losing $125,000 in a single month!

But, maybe you could. In fact, maybe you did. But thinking you can stand it and knowing you can are two entirely different animals. When I was in college, I was in great shape. Played racquetball or squash every day. Could stay on the court for hours.

So, when a friend of mine, a runner, asked me if I wanted to jog his five-mile trail with him, I thought, "No problem." For about a mile. And then I was dead.

Yes, what looked so easy on paper was so hard, so brutal in reality, I just couldn't stand it. And I had to give up and walk back in.

And by the way, it's this entire drawdown business that will kill off a good deal of the buy-and-holders, should we ever enter a prolonged bear market. I love these "man on the street" interviews after the market's had a bad day. They always key in on Joe Investor, who says he's never going to sell because the market always comes back.

But, the fact is, he's just lived through maybe a 3% down day! He knows nothing, and I mean nothing, about taking a licking day after day. In fact, I cannot fathom anyone who started investing anytime in the past 10 years -- basically 99% of the U.S. -- who could willingly sit there and not want to jump out a window as they see their kid's college education money sink by 40%!

The bottom line is that it's darn easy to have faith when you've never been called on to use it.

So, what's the key? The key is to think long and hard about what you could

really

stand to lose. And then start with that as a basis and build a strategy around that limit. And know, and I mean really know, that the Trading Gods will make good and certain these limits are eventually tested.

Look, it is brutal being wrong. It is even more brutal losing money. But most people shrug off the downside, thinking: a) they'll never be wrong, and b) when they are, they can certainly live with it.

But you will be wrong. And you won't be able to live with it. Just remember that before you start trading your "200% return" trading plan.

Gary B. Smith is a freelance writer who trades for his own account from his Maryland home using technical analysis. At time of publication, he held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Smith writes five technical analysis columns for TheStreet.com each week, including Technician's Take, Charted Territory and TSC Technical Forum. While he cannot provide investment advice or recommendations, he welcomes your feedback at

gbsmith@attglobal.net.