Ed Mamula.com

Lately, the stock market has been pretty volatile.  Since I’ve reduced the leverage in my forex trading, the daily absolute dollar swings in my 401K account are bigger than the swings in my forex account.  However, I keep noticing that the ups and downs in the stock market have absolutely no effect on my sense of well-being, while minor swings in my forex account can cause me to feel like a great success or a great failure.

For a while, I had been thinking that I just had too much of my ego invested in the success of *my* trading systems…when they win, I’m a winner…when they lose, I’m a loser…after all, they’re *my* systems.  I thought that the solution to this issue could be found by actively detaching my ego from the results, but this seemed difficult and ineffective.

Well, I now realize that there was at least one piece missing from the puzzle.  That piece is called “doing the right thing”.   You see, after years of being immersed in personal finance literature and financial media, I have an underlying sense that I’m investing my retirement money well by investing mostly in index funds, both domestic and international.  So when the market goes down, I can easily think that it’ll come back eventually (at least before I retire) and that I have nothing to worry about.

 BUT, with my trading systems, I have no underlying sense that I’m doing the right thing…it seems that the systems need to be tweaked often or they fall apart completely…a bit like the difference between buying a house and buying a car.  In the case of the house, present downturn notwithstanding, we can expect the value to rise in the long run…with the car, well, we know it’s destined for the junk heap eventually.

I reduced my risk per trade to 2% at the beginning of this week, and promptly experienced a 2% loss.  The pain of this relatively small loss was perhaps the worst that I have ever experienced, and I realized that my risk tolerance had completely evaporated.  I decided to shut down all systems until the end of the month.  Subsequent to this decision, Cable Glider booked a 250 pip gain, and closed the week in positive territory, but I did not participate.

 Each time I have experienced a significant drawdown with a duration longer than a couple of weeks, I have reduced my risk on my “next attempt” to trade with reasonable size.  I used to think it was okay to be a gun-slinger…after all, my risk tolerance isn’t going to INCREASE as I get older, right?

Well, here’s how drawdowns affect me…drawdowns are like a game.  The participant in the game (The Market) attempts to split a log (The Trader) with an ax.  If the ax does not strike with sufficient speed and power, it will make no mark on the log.  Such is the effect of a shallow drawdown that is quickly recovered.  It leaves no permanent damage.  What if the next drawdown is bigger?  The ax strikes with more power, cutting into the wood and leaving an impression that cannot be fully undone.  Now that the log has been damaged, subsequent hits with less power will damage it further.  Such is the effect of a drawdown that deep and / or not quickly recovered.  The trader’s risk tolerance is permanently decreased.

This story isn’t as cute as “life is like a box of chocolates”, but I think it describes my process well.  By the way, if you’re trading full time, Termites (living expenses) are eating the log every day as well!  Yikes!

 Interestingly enough, recovering from the deep drawdown isn’t enough to repair the trader’s damaged mindset.  I’ve gone through deep drawdowns and quick recoveries, and those are the times when I literally feel like I’ve dodged bullets…I’m happy to be alive, but deeply unnerved.

The only way that I know to break free of the pain of a drawdown is to do a true reality check and mental reset of goals and expectations.  There’s a powerful video that was posted earlier this week.  This IS what a blowup feels like.  I’ve been there, but fortunately I have not blown up my account for years…systematic money management is the best tool that there is for avoiding this type of catastrophe.

I am in the process of mentally resetting my risk tolerance, goals, and expectations.  Here’s the reality.  I have not blown up my account.  I have surrendered most of my profits.  I have to let go of the past and realize that this is outcome is much better than a blowup, and perhaps the best that I could hope for.  After all, what are the odds that I would ”learn my lesson” about risking too much after a substantial profit streak?  Something slightly north of zero…

So right now I’m still trying to figure out what my new level of risk will be, and how I will distribute it to my two trading systems that are live…time goes by so slowly when there is no action.