Wednesday, June 22, 2011

Trailing Low Threshold (Max Drawdown)

Given Loss Aversion, the painful effect of an unexpected loss is at least twice the joyful effect of an unexpected gain. One of the most frustrating scenarios in sports trading is moving into the black early in the day only to finish it in the red. Sound familiar? Psychologically, we reset the baseline to zero each day even though intellectually we may be focused on generating an annual income. Because we are loss averse it is not possible to simply ignore these daily downswings as it impacts our overall confidence level. I would recommend (even to those handicappers who do not accept session handicapping) setting a trailing low threshold. For example (specific numbers used for illustrative purposes only):
  • Day Bankroll: $1000
  • Max Drawdown: 20%
  • Low Threshold: $800 = (80% * $1000)
  • Day High: $1350
  • Trailing Low Threshold: $1080 = (80% * $1350)
In other words, even though you set an initial low threshold of $800, should you go into profit on the day ($1350) the low threshold is increased to maintain the 20% drawdown from the day high. This allows sufficient flexibility to continue trading without suffering the negative emotional impact of losing all your profit on the day.