Time Crunch Trading

You may be wondering at this point why all this matters if high returns are the overall objective. Shouldn’t we just accept any size drawdown so long as the total returns in the end are good?

That all sounds well and good, but it does not take in to account several important factors.  The first is the fact that the more your account value falls, the bigger the return required to make up that loss. The chart below shows this very clearly.

Notice how fairly small drawdowns only require small gains to be made back. For example, a 10% drawdown requires only about an 11% return to recover the portfolio’s value (10% lost divided by 90% remaining value = 11.11%).

As the drawdowns get larger, though, the required gain to get back up to breakeven accelerates rapidly. For example, a 50% loss in your portfolio value means you would have to make 100% just to make back the lost funds (50% lost divided by 50% remaining value = 100%).

Because large drawdowns mean that large returns are required to bring your account value back up to its starting point, they also tend to mean long periods between equity peaks. This is an extremely important consideration in understanding and then defining your risk tolerance.

As a part-time trader, you probably operate on a more extended timescale than is true for more active types of traders. That means you will take longer to recover from a significant decline in portfolio value. This is an important factor in your money management strategy. Be sure it is reflected as you plan things out.

Additionally, the combination of sharp drops your portfolio’s value and lengthy time spans making the money has the potential to be emotionally destabilizing. That can lead to you abandoning your trading system or methodology at exactly the wrong time.

In short, you must be able to accept the drawdowns likely to occur in your trading account’s value. You have to take that into consideration as you define the percent that represents your risk tolerance, both for single trade drops and portfolio value declines as the result of difficult spells. This is the high level starting point for your risk and money management strategy.

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