In today’s option trading blog I want to discuss how draw down can test your trading mettle. Let me distinguish this post from other related topics. This post is not going to deal with situations where I’ve been over exposed to risk, under capitalized or I’ve gone through the “big hurt” (bust). Those situations were fundamentally flawed from the start and I will write about them in the future. I’m happy to say, those learning experiences are in the past. Today, I’m talking about a normal 10% drop in my account when I’m doing everything right.

First I have to identify the nature and character of the loss. Most of the time it has to do with overall market conditions. For instance, if I’m trying to scale into a position and I know that I’m going against the market, I expect to take some heat and I can accept the draw down. That has been the case recently. I know that this pull back has created value and that by scaling in I can average my cost down on positions that look good – long term. I’ve been through enough of these to know that when the “spring” releases, the opportunity will vaporize. Face it, everyone else sees the reversal and they will be trying to get through the same door at the same time. Your reward for being early and taking some heat is that you will be “in position” when it happens. In this case, I need to make sure that the market is continuing to show signs that it is close to bottoming. I will stick with what I have and look for a bounce and continuation before adding.

Second I have to look at the nature of the losing trades. Am I losing money in a choppy market, where what’s up today is down tomorrow? If I can’t get any follow through on a stock, I need to adjust and wait for a pullback. There is a good chance that I will down-size my trades.

Third, I look at my market bias. Am I over-weighted on one side. If so, is my directional opinion still valid? I might need to rebalance and get my positions more neutral. I always try to carry a mix of longs and shorts.

Forth, am I weighted in a sector that is killing me? Did I miss the read? I need to make sure that I start unwinding positions if I have let myself “marry” a sector. A word of advice, “If you find yourself saying… these stocks have to go up, or these stocks are so over-valued they have to go down… you’re married.”

Fifth, am I just not seeing the trades well. This is the hardest issue to deal with. Everything else is in order, money is being made everywhere in the market and I’m in the wrong place at the wrong time. In this case, I unwind my positions as much as possible and I repair my psyche. It may take a few days, it may take a few weeks. Regardless, I can stop beating myself up and gain a clear perspective. The longer I wait and the more opportunities that pass me by, the greater my chances of a strong come-back. I will eventually get to the point to where the trades are so good that I can’t resist. The success will help me give me a fresh start and I can build from there. If I jump in and I’m wrong, I may have to keep my activity level down. After a rest, my first few trades are relatively small so they don’t hurt much if they don’t work out. Fortunately, that is not my pattern and my “hit” ratio is high.

The lesson to be learned is that draw downs are a part of trading. Sometimes they are the result of a plan (going against the grain in a scaled manner when you know you are early and you are looking for a sharp reversal), sometimes they can be corrected (rebalance your market bias) and sometimes you are just in a funk and you need to take a break. Take the time to review your trades and identify the source. Reduce your activity and regain your footing. It will pass if you let it.

It’s healthy to talk about your losses. Do you want to share? Post a comment.

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