The initial stop loss is set at the point of entry into the trade. In a pure Donchian Channel system, that stop is simply set at the first pip or tick outside of the channel in the direction against the trade. So if You go long at the break of a channel to the upside, you have a stop set just below the channel to the downside. Some traders (the Turtles included) use an initial stop distance that is based on something else like ATR (that is what the Turtles used) but of course a pure Donchian Channel system would just use the opposite side of the channel for the initial stop placement.
The more important consideration is next: Once you have determined that you will get in at a certain point and that you will place your initial stop at a certain point, you must set your position size. You may know for example that you are going to buy EUR/USD at 1.1500 with a stop at 1.1000. But how many units will you buy? 1,000? 10,000? 3,217? 2?
Most trend following traders (the Turtles included) choose a position size that will set the percentage of their equity which they will lose if their initial stop is taken out to a certain consistent amount such as 0.33% (33 basis points). (One basis point is one one-hundredth of a percent. Commonly, a number of basis points such as twelve basis points is written out as: “12bps” and pronounced “twelve bips”).
0.25% is zero point two five percent. It is 25 basis points and can be written “25bps”.
0.12% is zero point one two percent. It is 12 basis points and can be written “12bps”.
0.59% is zero point five nine percent. It is 59 basis points and can be written “59bps”.
0.31% is zero point three one percent. It is 31 basis points and can be written “31bps”.
A trend following trader may decide to risk 25bps per trade. So in the example above, the trader will set a stop entry at 1.1500 with a stop loss at 1.1000 and if his account is worth $10,000 he will want a position size that will risk $25 from entry to stop loss (10,000 x 0.0025 = 25, 25 is 25bps of 10,000). Because this trade puts 500 pips between the entry and the initial stop loss (11500-11000=500) he will want to risk $0.05 per pip (25/500=0.05). This particular pair will risk one cent per pip per 100 units traded. So if he puts on 500 units of EUR/USD with that entry and that stop, he will risk $0.05 per pip over 500 pips for a total risk of $25. So his position size will be 500 units.
If this trade is stopped out at the initial level, he will lose $25. He may have 40 trades all risking that same $25 amount going at once, but all of them risk that same $25 no matter what the pip distance is between his entry and his initial stop because he sets the position size to make the risk from entry to stop that same $25 amount. This gives him what many call “risk parity” which means he risks the same amount on every trade despite the pip distance between entry and stop.
So if this trader has ten straight losses in a row, he will lose 25bps or less per trade (plus any slippage) and thus accumulate less than a 2.5% drawdown as a result of those ten losses. Many times the stop will be groomed to a position wherein the trader will lose less than the initial 25bps, but it will not be groomed to a profitable position. Under such circumstances he will have a losing trade, but one that loses less than the 25bps. In that case he has a drawdown, but one smaller than his initial risk per trade.
The stop loss is never removed and allowed to stay in the market until it is taken out. It is simply groomed along the bottom of the channel on a long trade or the top of the channel on a short trade until it is taken out. This keeps your losses smaller than your wins. Your losses are limited to known small amounts while your gains can go on and on to win many times your initial risk. So one winning trade can win more than the accumulated losses from ten losing trades. That is the edge this type of system has: asymmetrical reward to risk ratios.
All drawdowns would be considered “normal” unless the trader overrode his system and put on a position size that would risk more bps than his predetermined level or he moved his initial stop against his trade.
When you look at the equity curve of a trader doing this kind of trading, you will see a smooth downward line as he loses many trades that give him very similar sized losses. But then that smooth line down will be interrupted by a big jump upward when big winners are closed. Then you will see another smooth decline followed by another big jump up.