The most important part of money management is the ability of a trader to avoid large draw downs. A draw down is defined as a trade or numerous trades in which there is negative performance. A draw down is a measurement of a recent peak period of capital to a recent trough period of capital. The measurement of a draw down is usually quoted as the percentage between the peak and the trough. A draw down is measured from the time a retrenchment begins to when a new high is reached. This method is used because a valley can’t be measured until a new high occurs. Once the new high is reached, the percentage change from the old high to the recent trough is recorded.
An example of how to measure a draw down can be seen from the chart below. In this example of the currency pair EUR/USD, the difference of .0327 = 1.5031 – 1.4704 is measured after the new high above the initial peak of 1.5031 is created. Once this occurs, the draw down is concluded and it can be effectively measured.
You should expect to have draw downs when trading, but the key to success is the ability to limit the draw downs to a specific percentage of the portfolio. The way you can avoid disastrous draw downs is to limit the position size to a percent of his portfolio that is manageable given the strategy you are trading. A simple way to measure this is to determine your risk tolerance. Risk tolerance can be expressed in terms of percentage.
For example, say that you are willing to experience losses of as much as 10% of the total investment in order to have the chance to earn higher market returns (rather than keep the money completely safe in a bank account.) If so, then you can express your risk tolerance as a percentage – 10%.
With this in mind, you would want to choose an investment strategy that has a Maximum Drawdown statistic of 10% or less. If you chose a strategy with a 20% Maximum Drawdown, it would be too risky for your expressed risk tolerance, and could potentially wipe you out. The maximum drawdown is a term that is used to identify the worse historical draw down a trader, or strategy has had since inception. This allows potential investors to understand in a historical perspective, the most that a strategy has lost and can potentially lose from peak to trough.
In the table below, the differences in risk profiles per trade can make an obvious difference in the draw down of a strategy over a period of time. In these two examples, a 2% maximum is placed on one set of trades, and a 10% maximum is place on the same set of trades over a 15 trade period. If the strategy suffered successive losses over the 15 trade period, the trades where 2% was risked would suffer a drawdown of 26%. On the other side of the table, the trades where 10% was risked per trade would suffer a drawdown of 79% over the 15 trade period. What is important to take from this example, is although losing 15 trades in a row is extreme, risk of ruin should be avoided at all costs. A trader also wants to have a sound money management strategy that can rebound into profitable territory, after they suffer a period of draw downs.
It is also important to understand the amount of money that you will need to make in order to make back capital from losses. Many novice investors believe that if you lose 10%, all you need to do is make 10% back to break even. But this is not true. If you start will $100 dollars and you lose 20%, you have $80 dollars. If you then make 20% on this amount ($80 * 20% = $16) you will then be left will $96 dollars, which is a 4% loss. The table below will give you an idea of the percent return needed to recover funds once a drawdown is suffered.
The key to a good strategy is to have sound money management techniques where you limit your draw downs and have a strategy that has a robust risk reward ratio where you make a multiple on a win, compare to what you lose on a loss. This type of strategy will limit your draw downs when they occur, and will allow you to preserve your capital and make solid returns.