IMPACT OF PROBABILITY AND DRAWDOWNS ON DAY TRADING

As Day traders we are attempting to make only high probability traders. In other words we only want to trade when we believe the odds are in our favor. If we want to take advantage of the probability factor, we should not change our trading strategies depending on profit or loss on individual trades. Whether we make profit or loss if we trade in a systematic and disciplined manner, we will still be in the game till the game till the end until we book profits, even if we incur loss continuously in first few trades.

Now we will understand how probability factor affects our trading by analyzing the individual and weekly results of two weeks in the form of a small statement.

If we compare the results of two weeks, we will find that at the end of every week we got profit in 21 trades and we incurred loss in 9 trades on average out of total 30 trades on every week. Our percentage of success for every week is 70%.

When we compare individual trades, we will find that we incurred loss in all our trades on both Monday and Tuesday in second week. Since we have proceeded with our trading strategy without changing or modifying it even after incurring loss in all trades for two days, again from Wednesday onwards the odds turned in our favor and we finally finished the 2nd week with our regular success rate.

So, it is very very important that if we want to take advantage of the probability factor, we should not change our trading strategies depending on profit or loss on individual trades. Whether we make profit or loss if we trade in a symmetric and disciplined manner, we will still be in the game till the end until we book profits, even if we incur loss continuously in first few trades.

Another important point in this probability analysis is to realize that regardless of the system or method you use to trade there will be occasions when you have losses or even string of losses. When these losses occur, it is important to have faith in your day trading technique and you should not lose faith or you should not change your trading techniques or methods depending on loss or profits you earn on individual trades.

The final point to be made in the above analysis is that as we can see from the above examples, any trading techniques or methods will go through tough times when it has more losses than wins. There is  where money management comes in to play. You should follow strict money management principles which helps you to stay in trading even if you incur losses continuously in all trades for few days. So if you want to take complete advantage probability factor, you should also follow strict money management techniques like following strict stop losses to keep all your losses small and utilizing only little multiple exposure on your margin money depending upon your trading methods etc.,

DRAWDOWN : Drawdown is a frightening word in day trading. But every day trader will experience some drawdown. In day trading, drawdowns are simply unavoidable. We can define drawdowns as the percentage of money we lose from our capital after finishing a trade. For example if you start day trading with a capital of $1500 and a few trades if you lose $300 your draw down would be 20%.

Now let’s say you make more trades and gain $600 which brings you to $1800($1200+$600 = $1800). After this on next trade you lose $300. Now your draw down would be 16.7% (percentage of $300 in $1800). The $1800 was your equity peak as that was the highest point in the period we looked at. Maximum drawdown is the lowest point your account reaches between equity peaks in a given period. For example, if you started your account with $1500 and the lowest amount you had in your account over a six month period was $750, then you had a 50% draw-down. You would need to make $750 from the lowest point in order to get back to break even.

MEASURING DRAW DOWN RECOVERY

Detailed table below shows how much percentage of profit you require to recover a given percentage of drawdown.

Draw-down recovery can confuse many traders. If a trader loses 20% of his account he thinks he needs to make 20% in order to get back to break-even. This is in fact not true. If you started with $1500 and lost $300 (20%), you would need to make 25% in order to get back to break-even. If you calculate $300 as a percentage of $1200 (not the original of $1500) it works out to 25%. As your draw-down increases, the amount you need to make back increases faster. Now you must be aware that following strict money management techniques is as important if not more important than your trading technique or trading system! 

To reduce draw-down in your trading career, you should you should concentrate on two important things. One is following strict risk management techniques and the other is following strict money management techniques.

In risk management, you should follow strict stop loss levels. You should minimize your losses by following strict stops and you should exit from a trade with a small loss if the trade goes against your expectation. If you stop, then you will be able to identify your risk.

In money management, you should not utilize too much multiple exposure on your margin money. If you use your multiple exposure on your margin money, the draw-down will multiply as per the rate of your multiple exposure. Suppose if you use 5 times multiple exposure on your margin and if you incur 4% loss on that trade, the draw-down would be 20% (4 x 5 = 20). 

If you habitually utilize 5 times multiple exposure and if you incur 4% loss continuously in 5 trades, you will lose all your capital and you will be thrown out of business. Even if you incur loss continuously in 3 trades, the draw-down would be 60% and you will be in do or die position to earn more than 150% of profit on your remaining capital to simply get back to break even. So, you should plan your money management in such a way that even if you continuously incur loss in 20 trades one after the other, you should be in a position to stay in the game till the end until you book profits, even if you incur loss continuously in twenty trades.

You should always remember that following strict risk management techniques and money management techniques is more important than following profitable day trading techniques and stock selection methods to earn profits in day trading. You should only risk a small portion, again repeat a small portion of your trading capital in one trade.

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Risk Disclaimer:
You must know that trading in stock market and currency exchange market has varying element of risk, and its is generally not an appropriate avenue for someone of limited resources or limited investment and limited trading experience and low risk tolerance. Further, trading in Stocks Market and in currency exchange market is regulated by and is subject to applicable laws in your jurisdiction and may or may not be permitted under such applicable laws. Before deciding to invest in stock market and currency exchange market you should carefully consider the applicable laws, your investment objectives, risk appetite and your current financial condition. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. In case you suffer adverse consequences or loss, you shall be solely responsible for the same

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