5 Ideas to Manage Drawdowns

Volatile markets can lead to volatile results. Learn about Larry's five ways to manage drawdowns.

5 Ideas to Manage Drawdowns

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Volatile markets can lead to volatile results. There have already been more than three times as many 1% daily moves in the S&P 500 this year than there were for all of 2017. Names like General Dynamics (GD) wiped out one year's worth of gains in eight days, from a new all-time high. 137 S & P 500 names are 20% or more below their 52 week high, and exactly 50% of S&P 50 stocks are below their 200 day moving averages.   

With increased volatility, and an increasing number of stocks in downtrends, this can wreak havoc on a traders equity, sometimes creating a pronounced drawdown. The fact is, drawdowns are a key part of trading or investing and most traders will be in drawdown mode quite often. Skilled traders have learned how to mitigate drawdowns, so that minor set backs do not turn into major setbacks. Here are a few key ideas to help:

1. Stop trading, or trade much less

A natural inclination for many is to try to "trade their way out" of a drawdown, which often does more harm than good. Traders often take on bigger trades to "get back to even" and as a result exceed their normal risk limits. When the trade fails, the drawdown becomes much bigger and now the trader gets into the cycle of taking more risk to get "back to even". This has many flaws. If driving 70mph on a rainy highway, if the car starts to get off track, giving it "more gas" is a recipe for disaster. The same applies to trading bigger. If the car goes off track, taking one's foot off the gas will usually allow the driver to regain control. Trading is the same. If I start to go into a consistent drawdown, with stops being hit along the way, I reduce activity, let the cash build and let open positions work. Taking on new risk and adding to open risk, opens the door for more pronounced drawdowns, if the new positions don't work either. 

2. Trade only your best ideas

Some markets are generous and a variety of different strategies can work. In choppier or more volatile markets, I look to focus on my "go to" approach, and once again, do less. This often means waiting for days or weeks for the right signals to generate, and monitoring a position for a longer time period. Yes, there are signals every day, but a trader doesn't need to "do something" every day. 

3. Focus on less volatile instruments

In general, single stocks offer more upside than ETFs. They also offer more risk and downside potential, especially during earnings season. In the last few weeks we have seen stocks erase months of gains in one or two sessions, based on an earnings report and the markets reaction. One way to reduce the event risk is to reduce exposure, or scale some of the position out ahead of earnings. Another option is to focus on ETFs, which due to lower volatility can offer a larger position size, and reduce the single stock earning event risk.

4. Take small victories

As a longer term position trader, I focus on a longer holding period. Certain market conditions are not always conducive to longer holding period as stock can go from new highs to stop loss levels quickly. In this environment, taking gains more quickly, whether partial or full. can add for incremental improvement and help reduce volatility in the accounts. 

5. When in doubt, it's okay to sit out

Steps 1 through 4 offer a solid approach, but sometimes that is not enough. Retail traders have the benefit of being able to go to very high or all cash at any time, and in some cases, this is the best approach for many, until market volatility dies down, or they feel more comfortable with their approach. 

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