The Trailing Draw Down Grift

It’s not uncommon for traders who work with prop trading firms to have their accounts “surrendered” (terminated) due to trailing drawdown. This can be a frustrating and demoralizing experience, especially if the trader was actually profitable over the long term.

So why do traders sometimes have their accounts surrendered due to trailing drawdown? One reason is that prop trading firms may have strict policies in place that dictate when an account must be terminated. For example, a firm may require traders to maintain a certain level of equity in their accounts or may set a maximum allowable trailing drawdown. If a trader’s account falls below these thresholds, the firm may decide to close the account in order to minimize its own risk.

Another reason why traders may have their accounts surrendered due to trailing drawdown is that the measure itself can be misleading. As mentioned earlier, trailing drawdown is a measure of the maximum decline in an investment’s value from its peak. However, it does not take into account the overall performance of the investment. A trader may have had a series of profitable trades, but if one large loss caused the trailing drawdown to exceed the allowable limit, the account could be terminated even if the trader was profitable overall.

In the real world, traders who are not affiliated with prop trading firms do not typically have to worry about having their accounts surrendered due to trailing drawdown. This is because they have complete control over their trades and can make decisions based on their own strategy and risk tolerance.

Imagine a trader who enters a long position in a futures contract with a profit target of $500. The trade initially goes well and the value of the contract increases by $450. However, the trader decides not to take profits and wait for the $500 target and instead holds onto the trade in the hope of achieving an even larger gain.

Unfortunately, the market begins to turn against the trader and the value of the contract starts to decline. Eventually, the trader’s stop-loss is triggered and the position is closed out with a loss of $500.

On the surface, it may seem like the trader has suffered a loss of $500 on this trade. However, when we consider the opportunity cost of not taking profits at the initial profit target of $500, the actual loss is much larger. In this case, the trader missed out on a gain of $450, which means the total loss is actually $950 ($500 loss + $450 missed opportunity). So, instead of a loss of $500 showing on the balance sheet, the prop firm’s Enron style accounting shows the account losing $950.

This example illustrates how trailing drawdown can be misleading and why it’s important to consider the overall performance of a trade, rather than just the maximum decline in value. It also highlights the importance of having a clear plan for taking profits and managing risk, rather than getting caught up in the excitement of potentially making larger gains.

In conclusion, while prop trading firms can offer some benefits, such as access to resources and support, traders may also face challenges, including the risk of having their accounts surrendered due to trailing drawdown. It’s important for traders to carefully consider the pros and cons of working with a prop trading firm and to be aware of the potential risks and limitations.