A question that comes up from time to time is how much of a draw down should a trader take before exiting a trade. My explanation is for those of you trading with some sort of frequency and not a buy and hold type strategy. The way this question is phrased can cause some cause for concern. The main issue with this is that there may be a confusion as to what a "draw down" is. For us here at emini room and universally to my knowledge, a draw down is generally the amount of loss your account takes before you arrive back to a profitable stage within a strategy.
Now I consider the entire period a draw down period, but your actual draw down is from peak to reversal. This is because a draw down as I see it is current or taking place until it is over. You don't know your actual draw down, rather you know you're in one until you're out of it. Lets put this into a more visual display to get a better idea:
Notice that a draw down is actually a period in which your strategy is producing negative results in comparison to your previous peak gain. It is the statistical deduction in account size from peak 1 as seen in the above visual description to the turning point(reversal). If you do some simple math and take the difference between these numbers you will get the draw down that you experienced. Not difficult to computate and useful if you take it a step further and look to find some average or mean of this period in your strategy. You can adapt and mold your strategy to eliminate some of the down period you may experience.
Now lets understand the difference between a draw down and stop loss. Generally when someone is referring to what you should allot as risk for a trade, you refer to this as a stop loss. Not a draw down as these mean very different things for most active traders. A stop loss is designed to prevent the max out of a draw down by decreasing your risk on each trade. So instead of peak 1 to reversal being taken down by one trade a trader wants to limit this by breaking it up and getting to the next possible successful trade. The goal of your strategy including your stop strategy is to eliminate the draw down occurring. Doing this helps to get back on track and allows for progress as it prevents a draw down from being to large in its path. Keeping the stop loss within reason and tailored for your account will help you to determine a strategy that works for you. You have to be aware that your strategy may be great, but if he draw down doesn't match your account or size you end up with a draw down of your entire account.
It's pretty simple really. Lets go back to my last point for a moment. Your strategy and draw down amount must be taken into account before beginning any trading. You must know first what you're willing to risk and what is your pain tolerance. Once you've established this you'll need to determine if your account will be able to take on the draw down to be expected. If not you're simply fighting a losing battle. Your approach should not be to say to yourself, "I'll just have to get going on the first run". The moment you believe the market can be that predictable is the moment you find your account depleted to next to nothing.
For me I like to keep things very small in terms of draw down. Say for example I was trading within an account of $10,000. I'd like to keep my max draw down to $1000 which is quite large as you can see, but as the account size gets larger this amount decreases through adjustments and rules. As things get better a trader will have a tendency to start really pouring on the contracts or taking more risk. This to me is something that should be done at certain intervals and until then a strategy should be geared and adjusted to prevent loss. Not to add loss.
FULL RISK DISCLOSURE: Futures trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing ones financial security or life style. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results.