Drawdown Control: How Pros Stay in the Game During Losing Streaks

Drawdown in options trading is something that affects all traders, regardless of their experience, skill level, or available capital balance. It describes the peak-to-trough decline in a trader’s portfolio value that can occur when an account is not properly managed and is at risk of being blown up altogether.

There are several reasons for the losing streaks that lead to these drawdowns, including:

• Incorrect position sizing that eats through a ton of unnecessary capital
• Emotional trading decisions that aren’t rooted in the original trading plan
• Traders straying from their original strategy when faced with unexpected losses

The difference between seasoned, professional traders with a lot of foresight and the newbie traders who don’t have a strong concept of what they’re doing is that the experienced investor is going to manage these drawdowns effectively to make sure they’re financially stable when they’re hit with options trading losses.

You have come to the right place to learn about how professional traders have developed the resiliency and psychological discipline to succeed in the face of portfolio drawdowns that create a roadblock in their trading plans. Not only will we focus on the psychological and portfolio damage that comes from unmanaged losses, but we’ll also highlight what professional traders do differently to give you a good guideline of how to deal with drawdowns in a competent and overcoming manner.

Suggested Reading: Options Risk Management 101 — Find out how you can proactively control downside in the options market and thrive during tough stretches.

Understanding Drawdowns in Options Trading

Before we dive into the different types of drawdowns you can encounter when trading options online, we’d like to briefly highlight the nature of drawdowns to give you a better understanding of what they are and what they are not. For instance, the decline in value that an options portfolio might experience is not a permanent loss for the trader—the account can recover and surpass its previous high point.

More or less, drawdowns are a useful tool for mapping out the loss potential for a portfolio and building up a risk management plan around those potential losses. Now that you have some of these ideas in mind, let’s dive into the different kinds of drawdowns that traders can examine to determine the right strategy and risk management principles.

Types of Drawdowns

• Max Drawdown: The largest drop from a peak in your portfolio’s value. Traders like to use this type of drawdown to map out a worst-case scenario for themselves and assess the worst risk possible.
• Absolute Drawdown: This drawdown focuses on the loss from the initial deposit to the lowest point that an account can reach.
• Static Drawdown: This represents a fixed drawdown limit that doesn’t change, but instead sets a hard limit on how much the account can decline in value before the trader is in violation.
• Trailing Drawdown: Traders can keep aware of the risks they face throughout the trading day, as the trailing drawdown is designed to move with the highest point reached by their account.
• Relative Drawdown: This kind of drawdown is useful for comparing drawdowns across multiple account sizes, as it expresses the max drawdown as a percentage of the peak equity that has been reached.

Options can amplify both gains and losses, so drawdowns can happen quite swiftly if traders aren’t careful with how they manage their positions. A few bad traders can screw things up quickly, unfortunately. Much of this is due to the leverage that can be had when trading options (borrowing money for speculation or hedging). Misaligned position sizing and “peak-to-trough volatility” can result in swings in capital that can happen within a short timeframe, leading to these major drawdowns.

Something else worth noting on the subject of drawdowns and their role in options trading decisions is that seasoned traders take the time to measure these drawdowns by percentage and by the dollar. This data can be used to track them against predefined limits. Remember that volatile markets can deliver losses before the expiration date to risk-defined spreads, which leads many seasoned pros to measure in both ways.

How Pro Traders Prepare for Losing Streaks

One of the primary differences between a professional trader and someone who trades options with a lot less experience is that the pro already factors in drawdowns as something that is inevitable in the trading experience. It is simply the cost of doing business, and drawdowns are a factor that needs to be prepared for and managed effectively for a harmonious outcome.

• Expectation Setting: Professional traders go into trading knowing that losing streaks are going to happen at a certain point, resulting in a drawdown of sorts. They have a knowledge of their trading strategy’s win/loss probabilities for a sense of how they can better deal with a drawdown when it inevitably comes their way.
• Historical Backtesting and Monte Carlo Simulations: Many professionals use these tools to find out what the worst-case scenario is in terms of a drawdown with the particular strategy they’re using and the investments they’re dealing with. Using backtesting or simulation tools gives traders a crack at running over 1,000 different scenarios to help them understand the potential risks at hand.
• Position Sizing Rules: Professional traders know when to use restraint, and one of the most common ways to do this is to use a small position size on any trade they take on (usually only 1-2% of their total capital is dedicated to a single position). Those with more insight into the market dynamics and who have a higher taste for risk can use the Kelly Criterion or volatility-based sizing to inform capital allocation.

Pro traders prepare for losing streaks well in advance, so they aren’t caught off guard when the losses come at them. Knowing ahead of time the maximum risks and the possible scenarios that could play out gives traders confidence in sticking with their original trading plan and not giving way to panic or emotional trading decisions.

Tactical Risk Control During a Drawdown

The potential dangers or challenges that come up when drawdowns occur in a trader’s portfolio require good, tactical risk management where the number one priority is to stop the bleeding and to mitigate any other relevant threats. In fact, when drawdowns happen, the smartest traders tend to slow down their trading activity and scale their position sizes down to protect their capital instead of chasing losses.

Dynamic Position Reduction (In a Nutshell)

• Reduced Position Size: Many professional traders will reduce their position sizes to half for a time to keep their potential losses to a minimum. This ensures that there’s no unnecessary money being put out there, which can mitigate a lot of risks over time.
• Making Position Adjustments: Smart traders will roll out their positions to a further expiration date, if it makes financial sense, to give the investment more time to make the money. Some even adjust the strike prices to further OTM status and keep the current timeframe intact to ensure their trades secure a profit.
• Hedging Strategies: Instead of scaling back on their trades or making position adjustments, some of the pros will simply offset portfolio exposure through hedging strategies like debit spreads or protective puts.

In addition to the position reduction measures that pro traders can take to control their portfolios in the midst of a drawdown, they can also cut losing trades earlier so as not to let their losses crop up too quickly. Cutting losers faster vs. letting them breathe is a delicate balance that takes time to learn—knowing the right move in each situation takes practice and experience.

Mental Resilience—The Psychology of Sticking with Your Edge

A lot of the challenges that come from drawdowns are, in fact, more psychological than they are financial. Traders can undergo a myriad of cognitive biases under pressure, including feelings or loss aversion that could destroy their performance given enough time, or the compulsion to overtrade that can lead to taking on too many low-quality positions to capitalize on “action.”

Traders can develop mental resiliency in a few ways through activities like daily journaling, debriefs, and decision logs. These systems can help traders to feel confident in their trading plan even when they’re faced with the slumps that come with portfolio drawdowns.

Psychological Effects of Drawdowns

• Loss Aversion: This mental state is where traders are more motivated in their decisions by loss than they are by any reward that could come from the same situation. As a result, losses can feel twice as painful as the potential gains could feel. Traders fall into more impulsive decision-making when they let loss aversion take over.
• Chasing Losses: Another downside of the psychological effects that drawdowns can have on traders is that they can fall into the habit of trying to make back the money they lost through additional trading. This can accelerate losses because the trader isn’t always entering quality trades, but is instead hoping to recoup losses through volume.

What is a pro to do when they’re faced with losing streaks that stem from drawdowns? In many cases, these seasoned traders will pre-set “stop trading” rules when certain drawdown limits are hit. This keeps them in the game trading, effectively avoiding the dangers of loss aversion, but it also keeps their risk level limited so they don’t get into the bad habit of chasing losses.

Building a Resilient Options Portfolio Structure

If you want to experience minimal impact from drawdowns in options trading, it starts with a proactive approach where traders are structuring their portfolios in a manner where they aren’t as susceptible to the’ downsides. Big surprise: a lot of this comes down to simply having a diversified portfolio. However, there are a few other tasks that traders have to complete to ensure they are building a resilient portfolio structure.

• Strategy Diversification: In addition to diversified investments, traders should also consider using a wide range of different strategies. For instance, they could be using non-directional trade techniques that you’d find with iron condors or calendar spreads, as well as direction plays that are based around price speculation, like vertical or debit spreads.
• Volatility Harvesting: Traders can do this across uncorrelated trades where they sell premium when the market is experiencing high levels of volatility. On the flip side, these trades can make money by buying premiums in low volatility environments.
• Don’t “Bet the Farm” on Any One Setup: Traders should avoid designing their portfolios around the same underlying asset because it undermines the principle of a diversified portfolio. It is best to spread investments around multiple underlying and in multiple sectors to ensure that overall portfolio performance remains strong.

Real Examples—How Top Traders Recovered

We’d like to present a couple of hypothetical scenarios involving two traders and how they reacted differently to a market drawdown. These case studies will zero in on the rules and habits that saved some traders from a severe market drawdown—you’ll find that there are a few different ways you can go about dealing with these events, and which strategy would work best for your personal trading goals.

• Trader A: This first scenario involves a trader who experienced a drawdown of over 20%. It was a drawdown of 25% to be exact, and the trader was able to recover from this slump by slowing down how frequently they traded. They also made a shift toward weekly spreads for the time, that is, until their portfolio performance normalized once again.
• Trader B: Another effective method for dealing with a drawdown can be seen with the second hypothetical scenario and trader #2. In this situation, the trader was in danger of incurring some serious losses from a meltdown in the biotech section. However, they pivoted their strategy to avoid those deep losses by putting together a volatility hedge that was composed of SPY puts.

The consistent theme you’ll see when studying these two hypothetical examples is that each trader has the foresight and experience to know that with drawdowns, it’s all about preserving capital first and then chasing profits second. Major drawdowns in a portfolio mean that traders need to shift into survival mode and begin to limit the bleeding as much as they can before using strategies that are about securing profit.

Action Plan—Your Drawdown Recovery Checklist

Let’s take a look at a simple action plan that you can take when dealing with drawdowns in your options portfolio. Consider this your drawdown recovery checklist, which you can consult to remain consistent with the best strategic practices that cater well to dealing with drawdowns.

1. Change the Position Size Immediately: The first step is to stop trading at full size when your portfolio loses a significant amount in value. Change your current position size to 50% of what it was or cut it back even further. This keeps you in the game but significantly reduces your potential risks.
2. Identify Patterns in Your Recent Losses: Look back on the last 20 trades you conducted and try to find patterns that could point to the source of the drawdown, be it the strategy you were using, the expiration date set for each position, or a market regime change.
3. Build Back Your Lost Equity Slowly: Take some time to gain back the equity your portfolio lost by scaling back up once the equity curve turns positive or flattens.

Get into the habit of keeping a daily checklist during a drawdown period. You can keep it up and visible in your trading workspace to remind you of the correct protocols to deal with these drawdowns and to prevent yourself from making reactive decisions based on emotions.

Lose Small, Win Long

Professional traders are bound to run into issues with drawdowns—it’s something that cannot be altogether avoided when it comes to trading options online. The thing that separates the pros from the bush league traders is how they keep their losses small enough to get through the drawdown and build back their portfolio to see another trading day.

Having a system in place for dealing with drawdowns can keep traders disciplined mentally and give them the ability to manage risks in a proactive manner. Pros know how to fall back on their trading plan and the confidence that comes with being systematic to weather drawdowns with the best of them. A systematized approach keeps them out of the troubles that can come from emotional trading decisions!

Remember: Capital preservation is profit generation in disguise.