Trading is a game of profits and losses; wins and defeats. It is a game of odds where high probability is the key to successful trading. A professional trader identifies a high probability trade opportunity and trades it using prudent risk management. If the trade moves in his favor, he stands to gain a big amount; and if it goes against him, he tends to lose a very small amount.
The novice trader, sadly though, understands the importance of risk management after going through many big losses and depleting his trading account considerably. Before he realizes the mistake, he would have lost more than 50% of his trading account. Most though, lose everything and give up trading.
With every wrong trade, the trader depletes his account size by a certain amount and then fervently tries to recover it. This back and forth movement normally follows a pattern. He goes back two notches and moves ahead one notch and thus never able to recover his losses. He entraps himself in this whirlpool and like a deadly quicksand, and pull himself till the death of his account.
Let us say that a trader has a trading capital of Rs. 1 lakh. He suffers from a loss of Rs. 50, 000/- or 50%. Most would say that he just needs a recovery of 50% to be at par, but this is not the case. He will need to recover by 100% actually to come to par again. Why?
Let us understand this using the example.
He has lost 50% (Rs. 50,000/- out of Rs. 100,000/- trading capital)
He has to gain 100% (Rs. 50,000/- out of the remaining Rs. 50,000/- trading capital)
Thus, simply put, if a trader has a drawdown of 50%, he will have to make a recovery of 100% to be at par.
Drawdown and recovery are very important aspects of risk management and should always be given a deep thought. Planning for losses in advance can help to recover from these swiftly or avoid these completely altogether.
Successful trading is more about prudent risk management rather than the accuracy of the trade itself.