Before you start to trade Forex you need to understand, your tolerance is to drawdowns or losses and this trading tip is all about this key point. While its not discussed much online and many traders never even think about it, understanding it and its impact is one of the keys to long term trading success.
In various experiments, traders have been given the exact same strategies to trade are monitored as they trade the strategy live in the markets. Keep in mind, the traders have the same strategies or rules so in theory, you would expect, these traders to produce the EXACT same results but this never happens.
Variation of Results with the Same Trading Strategy
At the end of the period some traders will make more money than others and some will be wiped out altogether. In the Turtle trading experiment – all the traders had the exact same rules and one of the Turtles Curtis Faith was trading it when it had a 70% drawdown (although it did eventually turn around into profit) while other traders stopped following the rules. Curtis Faith had a high tolerance to drawdown but other traders did not. Lets look at drawdown tolerance and in more detail, working out yours and how to follow a trading system with discipline.
Rational Decision Making v Impulsive Emotions
One of the most important traits of successful traders is to be able to make rational decisions while under pressure. In terms of trading the markets, the trader should be able to know, that decisions taken in relation to a set of rules have a high probability of a successful outcome and should be able to follow the rules to trading success but as we have seen earlier this doesn't happen as all traders have different tolerance to risk and drawdown.
The reason for this is we are not purely rational beings, we are also emotional and these two sides of our nature conflict, when we enter the real world of trading currency markets for profit. Money brings out the worst of emotions in people and this is especially true, when their under pressure to make money or expect, to make high returns on their trading signals. As soon as, a trading signal is entered in the market, the trader will feel the emotions of of fear and greed which can start to influence him in terms of following his trading strategy.
When this happens decisions are not rational not based on rational rules of a trading strategy but based on our emotional instinct which brings fear which is when a trader wants to preserve equity and greed, when he wants to maximize gains.
Drawdown Tolerance – Why Traders Underestimate It
When traders come to trade they fall into two groups there are those who believe that trading is easy and draw downs don't really happen or if they do there small and recovery to profit is quick and those who see a drawdown on paper see the number but don't realize how much impact it will have on them, when they trade the markets real time.
The traders who don't think drawdowns really happen and believe in easy money have zero drawdown tolerance and quickly crumble under the strain of real trading and need to go away and get some decent Forex education so they know how harsh the market can be then, they can join the second group who have seen typical drawdowns but need to stick to their trading rules and not be put off by them.
As we just said feeling a loss is very different to just knowing what it is, traders always tend to over leverage when they start which by its nature creates sharp drawdowns and new traders also do not understand the feeling of how a drawdown feels for a long period of time. Any mechanical trading system will drawdown for months on end at some point and the same happens in non discretionary accounts and this is why drawdown tolerance is so important.
You need to know, how much you can take as a downside fall on your equity and how long you can stand it. In most instances drawdown plays havoc with the traders decision which sees a deviation from the system rules, to fight the drawdown and get the account back to profit. The trader will trade more to get money back average down, manually override the trading signals and lose confidence until they either just quit trading or lose, all the money in their trading account.
The problem with deciding how much risk tolerance you can take is not something you can learn from a book - you have to feel the pain which means you have to feel your emotions. So what is the best way to get used to risk and drawdown trading for real in the markets?
Checking Your Tolerance to Risk
You need to decide your risk tolerance in the real world of trading and do it in the following way. In terms of percentage of equity, you think you can take as a loss, cut it in half and start to trade and see, how you feel when you enter a drawdown period. If you can handle it for a few months, go up in terms of the risks you are taking – the important point is you need to know how it feels to understand how it can make you deviate from your plan. Once you have tested your tolerance to risk you can them increase it, because you have tested your emotions and seen if you can control them.
Another key point which will tell you, if you are taking to much risk is to check if your profits make you happy and your losses make you sad. If they do, you need to cut the level of risk you take. If you’re feeling emotional about your trading, your risk level is too high. You should feel no emotions, as losses or profits are taken because you are within your risk tolerance and you are likely to follow your trading plan with discipline.
Most traders don't think about risk because they would rather focus on the profits they can make after all money management and losses, are boring compared to profits but the serious trader knows, that not only does he need good risk control on his account, he also needs to know how much risk he can tolerate, to stop his emotions getting involved and allow him, to trade his Forex trading plan rationally and with discipline. So make understanding your risk tolerance, part of your Forex education and it will be time well spent.