Tales of a Technician: Recovering from a Drawdown is Glorious

Perhaps no event in trading is as satisfying as recovering from a drawdown. It delivers vindication, validation, and glory. I know this because I’ve experienced it countless times in the past and, well, I finally clinched victory again last week. Today I want to discuss the dynamics of drawdowns and provide ideas for ensuring your recovery.

Think of a drawdown as a drop or loss in your account value. If a $50k account falls to $45k, then we would call that a 10% drawdown. Unfortunately, these periodic descents are inescapable. You can’t outrun them no matter your speed.

But you can outlast them if your system is sound and if you possess the emotional fortitude. Warren Buffett said,

“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.”

Think about this statement for a second. For starters, it applies to buy and hold investors. It teaches that you have to understand the volatility you will face when investing in an asset or trading a particular strategy. If you can’t handle the gyrations, you’ll undoubtedly sell at the worst possible time.

The same can be said of trading systems. Consider our beloved Condors for Cash Flow system, for instance. If you lose two months in a row, you will see a drawdown nearing 70% of your invested capital. Three losing months in a row could cause you to lose 100% of your invested capital. Can you stomach that type of adversity? If not, I can promise you’ll quit at the exact wrong time when employing the system.

I can sum up my job as a trader in three simple phrases:

One: Build a system that makes money over time. In geek-speak we say it has a positive expectancy.

Two: Size the capital invested properly so I can withstand any and all drawdowns.

Three: Don’t quit in the midst of a losing streak. Keep going!

There is only one way to prevent a temporary drawdown from becoming permanent: keep trading. Now, that assumes, of course, that you have a good system and are following the rules. Obviously, if you have a bad system then it’s continual implementation will lead to ruin.

This truth is manifested anew every time I see my account value recover to its previous high water mark. It reassures me that my methods are sound and the only thing that my account needs to recoup losses is time.

Before the late-January rug-pull, my account value was perched at a peak heretofore unseen. Then, the S&P 500 slipped, nay, crashed 10% in just a few trading sessions delivering a similarly sized drawdown. Fortunately, I’ve seen this movie before. And I know the ending.

So I got smaller, used volatility to my advantage, kept the long game in mind and waited for fat pitches. And then, finally, last week my account returned to its prior peak. The hole has officially been backfilled, and my methods have once again proven effective.

Now, the temptation to call it a day, to head to cash once the market was 10% off its highs (I’m talking Feb 9th) was real. Seeing a portfolio melt is always spooky, even for veteran traders. To elaborate and re-iterate here’s what kept me in the game.

One: My sizing was sound. I’m an unabashed stickler on this. I never, no never, risk more than 1% to 2% of my portfolio in each short-term trade.

Second: I was willing to allow assignment on each naked put if the market didn’t recover by expiration. The plan would have been to sell covered calls then until called out.

Third: I own some IWM for the long run (likely forever) and had protective puts and covered calls before the crash. This turned a potential two-by-four to the face into a toothpick stab.

Fourth: I’m playing the long game and don’t mind taking a few months to see an account recover. While some shortsighted traders hellbent on forcing their will on the market and trying to make money every day got chopped to pieces, I said, “screw it,” and went golfing.

Lest you think I’m tooting my own horn — I’m not. Trust me, I’ve made a few blunders (like mismanaging a bear call hedge like a friggin’ noob) and failed to take full advantage of some fat pitches.

Keep these principles in mind next time a drawdown strikes.