Anyone with enough experience in the financial markets knows it's impossible to get every trade right.
Even volatility traders that target high-probability approaches expect to lose on a certain percentage of their trades. While the goal is to turn a profit on at least 51% of our positions, most traders would obviously welcome something in the 60-65% range (or higher).
By targeting structures with a high probability-of-profit (POP), and deploying such positions in high numbers (i.e. many instances), that's when our portfolios typically perform the best -- meaning we get as close to our target POP as possible.
Because we aren't winning on 100% of our trades, there will of course be instances in which our trading accounts experience drawdowns. In the trading world, a drawdown refers to a drop in equity in the portfolio value.
When volatility spiked near the end of 2018, it's likely that some short premium traders experienced a drawdown. That's one reason that here at tastytrade we never deploy 100% of our capital when volatility is low. If one is 100% invested when volatility spikes, then there's no way to capitalize on heightened levels of volatility.
While every trader needs to manage his/her own capital deployment based on their own unique trading approach, the graphic below highlights one possible mindset when approaching this subject:
If you want to learn more about drawdowns, a new installment of Best Practices is definitely worth a few moments of your time. This episode provides additional perspective on the subject and may help traders better manage these difficult circumstances.
It's important to note that a "drawdown" doesn't necessarily refer to a loss in our trading account. For example, imagine a trader that started with $20,000 in his/her account, which increased in value to $40,000. If that same account dipped to $30,000 (which would still represent a net profit) the account would still technically be "drawn down" by $10,000, or 25%.
In that sense, drawdowns are usually described by a peak high to a trough low, as seen in the previous example. Drawdowns are also usually expressed in percentage terms.
When talking about drawdowns, one of the biggest considerations are of course the ongoing risks. If an account value drops by 1%, for example, that's obviously not a huge event. The real risk comes when the drawdown percentage jumps into the double digits.
For example, if any account is drawn down by 20%, then the value of the assets will need to rally by 25% in order to get back to "even." The graphic below, taken from the aforementioned episode of Best Practices, helps illustrate how difficult it can be to get back to even after significant drawdowns:
On Best Practices, the hosts review potential tactics that traders can use to help avoid drawdowns, or at least to mitigate risk once a drawdown has occurred. Likewise, they also review some of the "bad behavior" that traders often leverage when trying to "comeback" from a drawdown.
Due to the strategic importance of this topic, we hope that you'll take the time to review the complete episode of Best Practices focusing on drawdowns when your schedule allows.
If you have any questions about drawdowns in general, or a specific position that’s been challenged, we hope you'll reach out by leaving a message in the space below, or contacting us on Twitter (@tastytrade) or email (firstname.lastname@example.org).
Thanks for reading, and we look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.