Trend Following Draw Downs

Over the past two weeks, many of my positions moved against me very sharply, and most were stopped out. One of the foundations of trend following trading is to take small losses, but what occasionally happens is that many small losses will begin to add up to a large loss. When this occurs, it is referred to as a draw down.

As far as I can tell, all trend following traders experience draw downs, and it appears to me to be an inevitable cost of doing business. But what can make a huge difference is how trend followers handle losses. Here are some tips that I have picked up from other great traders on how to mitigate draw downs:

1) Cut Losses

I always place my stop loss orders immediately after a trade goes through. This way, when a draw down occurs, positions are stopped out quickly, and without a lot of the psychological issues that plague traders that use mental stops or no stops at all.

2) Get Small

If your account is shrinking in size, then so should your positions. If you traded 100 shares when you had $10,000 then you should only trade 50 shares if you are down to $5,000. This is is sometimes referred to as an anti-Monte Carlo money management system. During favourable periods, my portfolio will become larger, which helps it grow exponentially. During difficult times, my portfolio shrinks, which helps keep losses linear.

3) Spread Out Positions

All great trend traders spread their account over many different asset classes to help prevent draw downs. A portfolio that is too heavily concentrated in one area runs the risk of being wiped out by a large black swan type of event.

Here is a graph I found on Michael Covel's blog. I think it is a reasonable guide to helping diversify one's portfolio. As you can see, stocks are a relatively small component, but there are numerous ETFs that can provide exposure to almost all of the other categories:

4) Get to the Source of the Problem

This recent draw down caused me to go into a margin call. I think that once you are in a margin call, you should not add additional funds into an account. Positions should be eliminated instead. The positions that should be eliminated should be the ones responsible for the margin call. So, in this case, my margin call was caused by shorts being squeezed, which means that I should cover shorts; not sell longs.

5) Take a Break

After a loss, it is tempting to try to immediately trade again to quickly recuperate those losses. Because losses can be emotionally destabilizing, this kind of revenge trading usually only exacerbates the problem. A lot of the books I've read seem to recommend taking a rest until your mind is clear again before trading.