Recovering from Drawdowns: A Practical Guide

You're down 15%. Your equity curve, once so promising, now shows a jagged descent. Each day you check your balance, hoping for a recovery that doesn't come.

This is the drawdown, and every trader faces it. What separates traders who recover from those who blow up isn't luck - it's how they respond.

Understanding Drawdowns

A drawdown is the decline from a peak equity to a trough before a new peak is made. If your account hit $50,000 and now sits at $42,500, you're in a 15% drawdown.

Drawdowns are not optional. Every strategy, no matter how good, has them. The question isn't whether you'll experience drawdowns - it's how deep and how long.

Normal vs. Abnormal Drawdowns

Your backtest should tell you what's normal for your strategy:

Normal: A drawdown within the range you've seen in testing. If your historical max drawdown was 18%, a 12% drawdown is concerning but expected.

Abnormal: A drawdown that exceeds anything in your testing. If you're down 25% when your worst backtest drawdown was 15%, something may have changed.

This distinction matters because the response is different.

Responding to Normal Drawdowns

Step 1: Verify Nothing Is Broken

Before assuming the strategy is fine, check:

• Are trades executing as expected?
• Are fills reasonable (no unusual slippage)?
• Is the strategy behaving according to its rules?
• Have market conditions changed drastically?

If everything checks out, the drawdown is likely variance, not system failure.

Step 2: Don't Change Anything

This is the hardest part. Your instinct screams to do something - tighten stops, reduce size, add filters, change parameters.

Resist.

Changes made during drawdowns are emotional reactions, not analytical improvements. You're optimizing for recent data (the losing trades) at the expense of your full dataset (your backtest).

The strategy that made money will likely continue making money if the edge is real. Drawdowns are the price you pay for that edge.

Step 3: Review Your Sizing

There's one legitimate change during normal drawdowns: if your position size feels too painful, you may have been oversized.

This isn't about optimization - it's about your personal risk tolerance. If a normal drawdown is causing you to consider irrational changes, your size was too large for your psychology.

Reducing size during a drawdown is acceptable if it's about long-term sustainability, not short-term panic.

Step 4: Wait

Normal drawdowns end. Not always quickly, and not always smoothly, but they end. Your edge, if real, will reassert itself.

Set a reminder to review in 30 days. Don't obsess daily. The watched pot never boils.

Responding to Abnormal Drawdowns

When your drawdown exceeds historical norms, the calculus changes.

Step 1: Reduce Size Immediately

An abnormal drawdown means something unexpected is happening. You don't know what yet. Reducing size limits the damage while you investigate.

Cut to 25-50% of normal size. You can always size back up when you understand what's happening.

Step 2: Analyze the Losing Trades

Look for patterns:

Execution issues: Are you getting worse fills than expected? Has slippage increased?

Market regime change: Has volatility shifted dramatically? Are correlations different? Is the market behaving unlike your backtest period?

Strategy decay: Does your edge appear to have eroded? Are win rates or average wins significantly below expectations?

Data or technical problems: Did something break? Are signals generating correctly?

Step 3: Compare to Baseline

Pull your backtest results. Compare recent performance metrics (win rate, average win, average loss, trade frequency) to historical averages.

If metrics are within 1-2 standard deviations of normal, you might just be experiencing tail risk - a normal but rare event.

If metrics are far outside normal ranges, something fundamental may have changed.

Step 4: Decide: Persist or Pause

Persist (at reduced size) if:

• Execution is clean
• Metrics are within historical variance
• Market conditions are unusual but temporary
• You believe the edge still exists

Pause if:

• You can't explain the underperformance
• Metrics are far outside historical norms
• You've lost confidence in the edge
• The drawdown threatens to breach your maximum loss limit

Pausing isn't failure. It's risk management. The market will be there when you're ready.

The Recovery Phase

Once you've stopped the bleeding - either by waiting out a normal drawdown or addressing an abnormal one - recovery begins.

Don't Chase Recovery

The worst response to a drawdown is trying to make it back quickly. This leads to:

• Oversizing (to make bigger gains)
• Overtrading (to have more opportunities)
• Taking lower-quality setups (to be in the market more)

All of these make the drawdown worse, not better.

Recover at your normal pace. The same strategy and sizing that got you profitable before will get you there again.

Understand the Math

Recovery from drawdowns is asymmetric. A 20% loss requires a 25% gain to recover. A 50% loss requires a 100% gain.

This is why deep drawdowns are so dangerous - and why managing drawdowns is more important than maximizing gains.

Track Progress Without Obsessing

Check weekly, not hourly. Note your high-water mark and current balance. Watch the trend.

Recovery can be slow. A strategy that makes 3% per month on average will take 7-8 months to recover from a 20% drawdown. That's a long time.

But it's better than blowing up trying to recover in 2 months.

Preventing Deep Drawdowns

The best drawdown recovery is not needing one.

Size for Worst Case

Your position size should assume your worst historical drawdown will happen - and might be exceeded by 50%. Can you survive that?

If not, reduce size until you can.

Use Hard Stops

Daily loss limits, position limits, and drawdown circuit breakers prevent recoverable drawdowns from becoming unrecoverable ones.

In Algo Bread, set these limits and don't override them when you're down. That's exactly when they need to hold.

Diversify Thoughtfully

Multiple uncorrelated strategies smooth your equity curve. When one is drawing down, another might be advancing.

This reduces both the depth and frequency of drawdowns on your total equity.

Maintain Cash Buffer

Don't trade 100% of your capital. Keep a reserve. If a drawdown takes you below comfortable trading size, you have buffer to continue rather than being forced to stop at the worst time.

The Mental Game

Drawdowns test your psychology more than your strategy. A few things that help:

Zoom Out

That 15% drawdown looks terrifying on a daily chart. On a monthly chart of your entire trading career, it's a blip. Keep perspective.

Review Your Edge

During drawdowns, remind yourself why your strategy works. Look at the backtest. Look at past profitable periods. Remember that variance isn't the same as broken.

Accept Impermanence

This drawdown will end. The next winning streak will end too. Both are temporary. Your job is to ride both without making stupid decisions.

Talk to Other Traders

Isolation makes drawdowns worse. Other traders understand what you're experiencing. A conversation can provide perspective and prevent panic.

When to Quit

Sometimes, the right answer is to stop trading a strategy entirely. Signs that it might be time:

• Sustained underperformance beyond any historical precedent
• Market structure changes that invalidate your edge
• Your psychology can't handle the variance
• Better opportunities exist elsewhere

Quitting isn't failure if it's a reasoned decision based on evidence. It's failure only if you quit emotionally at the worst moment and miss the recovery.

The Long Game

Professional traders expect drawdowns. They plan for them, budget for them, and survive them. The amateur trader is blindsided, panics, and blows up.

Your goal isn't to avoid drawdowns - that's impossible. Your goal is to size so drawdowns are survivable, respond so drawdowns don't become disasters, and wait so drawdowns can end.

This too shall pass. Trade accordingly.