The Psychology of Drawdowns

12/18/2009 12:01 am EST


Trading psychology is the most important aspect of a trader's success. This may surprise some readers, specifically those who are new to trading. However, the psychological makeup of a trader is more important than market knowledge, market analysis, and even money management. The reason psychology is so important is that even the best information can be distorted by a poor mindset.

Most new traders think the key to profiting in trading is knowing more about the market. For instance, most new traders clog their screens with every indicator they can find, read up on European GDP trends, and feel that pro traders have some sort of secret knowledge. However, this inevitably does not provide the lofty results the novice trader expects to achieve.

After realizing that excessive market information doesn't help (and may hurt) results, the next moment of truth most traders have is money management. Instead to trading one lot every time, or even trading the maximum lots their account will allow, these traders realize that losses will happen no matter what. When you realize that everyone loses on occasion, it is easy to see why money management is necessary. This is a big step, but does not ensure success.

Now, don't get me wrong, you need to have some form of analysis and some form of money management to profit in the long term. In other words, you need an edge that when applied with proper money management leads to positive returns over the course of many trades. Great money management with no edge will only mean you lose your money more slowly. A great strategy without money management will lead to an inevitable blow up. However, without the proper mindset, it is nearly impossible to continue to get good results in the long run.

The bottom line is that a poor mindset can sabotage even the best trading strategy or money management strategy. I could write about this at great length, but we will look at one key example for now. The biggest test in trading psychology occurs during a drawdown. This occurs when a trader gets in a "slump" and has bad results for a given period of time. Usually the most devastating drawdowns eliminate a significant amount of hard-earned profits.

Keep in mind, drawdowns are completely normal. Everyone has them on occasion, but the key is reacting properly to them. This is why trading psychology is so important. The natural reaction during a drawdown is to change your strategy. Sometimes traders will even take trades for no reason whatsoever except for a desperate chance at a profit. Assuming you believe your methodology is sound, there is no reason to change anything during a drawdown. In fact, that is the most important time to follow the basics. Think about a baseball player in a hitting slump. Sometimes they will change their stance, but usually they keep the same basic stance and swing. Instead, they focus on the fundamentals of keeping their head still, keeping their hands back, and so on. For some reason, traders tend to panic in this situation and change everything up. This leads to a larger drawdown, which usually ends when the trader reverts back to their primary strategy.

In conclusion, the steps above illustrate the general process a trade takes on the road to achieving consistent results. Virtually all traders only become successful after they able to put together a strategy that gives you an edge, money management, and proper trading psychology.

By Bradley W. Gareiss of

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