In an effort to reiterate the importance of risk management in trading I wanted to talk about the concept of ‘Drawdown Recovery’ in this CFD Tutorial.
Drawdown simply put is the amount of money a trader loses when trading. Most people with then express this figure as a percentage in relation to the trading capital; they started with. So let’s take the example of a trader who starts with $10,000 and takes there first trade which incurs a loss of $1000. In this instance the Drawdown is 10%. The process of recouping these losses is referred to as ‘Downturn Recovery’ and this becomes increasingly difficult as drawdown’s increase. Take note of the Drawdown diagram below which illustrates the correlation between Drawdown and drawdown recovery.
In the example used above the $1000 loss with $10,000 trading capital was a 10% drawdown. Yet to turn $9,000 trading equity into $10,000 is an 11% gain (drawdown recovery). As you can see in the graph the relationship between Drawdown and Drawdown recover is a harsh one with the Drawdown recover being exponential as drawdown increases. I can’t say it enough but capital preservation is vital in trading.
Re-Visiting Entry & Exit Points
It is important that traders follow their positions progress and then adjust stop losses accordingly. A lot of traders make the mistake of thinking it’s less painful to lose unrealised profits than it is to lose cash out of their wallet. This can be a costly mental habit to inherit along the way. The way to avoid this is to move your stop loss up as your winning trade moves up/down into positive territories. Not only will it lock in profits without you having to second guess the point of exit but also allows you to take more risk on new trades knowing that the core equity is higher now. To achieve this some systems like WebIress have trailing stop loss functionality to enable the trader to not have to manually move this stop. By using a stop that moves itself means you don’t have to continually monitor the position and move the stop yourself and secondly it takes control away from the trader who potentially can make a bad decision.
Avoid moving a stop backwards from the initial price. Stops should only ever be moved to reduce risk never to increase risk.