By: IntegrityFX
An important aspect of trading is that recovering losses is harder than losing them. While this may be true in a few aspects, this article will just focus on the mathematics involved. In order to fully recover from a loss or drawdown, the percentage growth of the recovery is always higher than the percentage growth of the loss.
For example, if a trader starts with a $1,000 account and then loses $500, that is a 50% loss, and the account is then at $500. In order to recover the loss and bring the account back to $1,000, a growth of $500 is needed. This $500 of the $500 account balance is 100% growth. The 100% growth for recovery is 2 times that of the 50% loss.
The table below shows different loss or drawdown levels and their corresponding recovery growth, as well as the ratio between the two (i.e. the recovery divided by the loss).
Note that the recovery and recovery / loss ratio grow exponentially as the size of the loss increase. Therefore, the larger the loss, the harder it is to recover from it and this difficulty grows exponentially.
Taking on too much risk can lead to very large drawdown from which it is extremely difficult to recover. Imagine making 400% growth. That is an exciting feat for traders, but had it come after 80% drawdown, then that 400% growth merely led to breaking even. Large drawdown can turn what would normally be a great achievement into a lackluster event.
This all highlights the need for sound risk management. If traders can formulate their risk management model to limit the estimated maximum drawdown to roughly 10-20%, then that puts them in an excellent position. If that drawdown occurs, then their road to recovery is not significantly more than their loss and it's more manageable. Traders may wish to risk more or less based on their individual risk appetite, but it's important to not be too aggressive. Sound risk management protects the account, protects the ability to recover from losses, and protects long term sustainability in trading.