What DrawDown is and how to manage it
An important indicator in order to assess the value of a trading strategy is the maximum drawdown.
It is important for an algorithmic trader to take into consideration the level of drawdown while testing a strategy. Sometimes it is more important to know the expectation of losing money, instead of the amount of money that could be raised by using a trading system.
A trader must consider drawdown, but how can he calculate it for his strategy? I surfed many webpages explaining what drawdown is, but it was quite hard for me to understand its meaning, until I found this simple example .
It explains that drawdown is a measurement of the risk and drawdown measures the percentage peak going from the top value of your portfolio to the lowest one reached relatively to that maximum. Let's now provide an example in order to be clearer.
2.97% is the maximum drawdown for this backtest, all the others are considered relative drawdowns
As it is shown by the above chart, each time a new peak is reached, the trader has to start evaluating the maximum distance going from ng it is important to evaluate the worst case scenario that is explained exactly by the maximum drawdown.
What is the formula for maximum drawdown?
It is quite easy to calculate it. The formula is the following one:
So for example if the previous peak for the equity was 11.000$ and now you have 10.000$ after some trades, it means that you are facing a drawdown equal to 1.000$/10.000$, that corresponds to the 1%. If such 1% is the maximum ever registered, well, here I have a maximum drawdown.
I use the following parameters in order to evaluate the quality of a trading strategy taking into account drawdown.
1) Maximum Drawdown atleast half the total interest rate per year. Thus if I face the maximum drawdown I can expect to have my money back within 1 year and no more (statistically speaking)
2) Maximum Drawdown cannot be higher than 15%. This is a personal rule. I think that everyone has got a level of loss unable to accept, well, 15% is my maximum.