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"How to successfully trade commodity futures, options, stock indices, stock market & forex markets"
Two Ways To Report Max Drawdown. One Is Much Easier To Take
Maximum drawdown excursion is a very important figure which
is normally reported as one of the major factors in analyzing
a trading system by historical testing software. It is generally
defined as the greatest decrease in equity at any time
during the testing period under consideration and it
is usually reported both in terms of actual dollars
and as a percentage. Click-here to Learn how to trade forex in 90 seconds!
Recently I realized various in testing software programs about
how to make money in commodities trading differ in how they report
this figure. The two biggest variations seem to center
around whether or not the maximum drawdown figure is
based on closed trades only, or both open and closed trades.
Open and closed trade calculations: When maximum drawdown
is based on open and closed trade equity it will tend
to vary every day that any trades are in progress. The
benefit of this figure is that it monitors daily fluctuation
in equity throughout a trade or a portfolio of trades.
The limitation of figure is that it counts losses of
open profits as actual trading losses.
For instance, let's say you are trading a system and
you currently have open trades in 4 markets: JY, SF,
BP and DX. All the financial markets are moving well and you have
a current open profit of $5,000 per market or $20,000
total. Then, as it often happens, the markets move against
you and your long-term system doesn't get you out until
you have lost half of your open profit. So, you exit
the 4 trades with $10,000 in profit. This would be common
of many long-term systems which allow a market to move
a large amount against you before exiting the trade
as a trade-off for giving the market room to stay in
the major moves.
The problem is that these 4 profitable trades will
be reported as a $10,000 drawdown since you had a $10,000
loss in open equity. If this period were immediately
followed by an extended period of closed trade losses
totaling $10,000, those total losses would be added
to the previous open profit drawdown of $10,000 to arrive
at a new figure for maximum drawdown of $20,000. In
this case half of the maximum drawdown figure would
represent actual closed trade losses and half would
represent decrease in open trade profits.
Closed trade calculation only: When maximum drawdown
is based on open and closed trades it will only vary
when your system exits a trade. The only factor taken
into consideration is the affect of actual closed profits
and trade losses.
The limitation of this figure is that it does not tell
you anything about open equity when you are currently
in trades. The benefit is that it reports the important
maximum drawdown figure only on the basis of actual
losses.
Let's look again at our above example where you were
currently in 4 trades in 4 currency markets. In that
scenario the system would report a $10,000 profit and
0 drawdown since you actually made money upon exiting
the trades and you did not actually lose any money.
Personally, I am more interested in knowing the maximum
drawdown based on closed trades since that tells me
the greatest decrease in capital I could have had if
I had started trading at the worst possible time, although
it's true, drawdown figure will change even over the
same testing period depending on when you start the
test.
There is a vast difference in going through a drawdown
of $20,000 in actual capital and in going through a
$20,000 drawdown in open profits that ultimately ends
up as a profitable trade. Also, there is a big difference
psychologically.
My complaint with reporting maximum drawdown as a percentage
is that it is usually based on the greatest percentage
decrease in equity at any time during the testing period.
This would often include equity based on open and closed
trades which I have already given my opinion concerning.
The other problem here is that it is a figure that
is based on the current equity which begins as the initial
start-up capital and by design it will almost always
identify the greatest decrease in equity by percentage
to be in the earlier years of a test. This stands to
reason since equity will generally increase over time
with a profitable system.
If you begin with $50,000 in capital and immediately
have a $20,000 drawdown, then that number represents
a 40% drawdown. However, if you initially have some
profitable trades and ultimately double your capital
to $100,000, the same $20,000 drawdown now only represents
a 10% decrease of your capital. It ends up telling you
more about how early in the testing period a drawdown
occurred than how large it was.
Personally, I'd rather see this percentage refer to
the same maximum closed trade drawdown period which
the dollar figure drawdown refers to. My own spreadsheet
calculations, if correct, indicates a closed trade max
drawdown will often be much less than open trade max
drawdown.
One system I compared had an open trade maximum portfolio
drawdown of approximately $47,000 and a maximum closed
trade portfolio drawdown of approximately $39,000 or
17% less. Another trading system had a open trade maximum portfolio
drawdown of approximately $36,000 and a closed trade
maximum portfolio drawdown of approximately $16,000
and represented an equity drawdown which was 56% less.
The difference in these numbers could make the difference
in a trader deciding whether or not to purchase or trade
a system. Also, the method of calculation of maximum
drawdown based on open trade equity might tend to encourage
system developers to design long-term systems to exit
trades quicker in order to limit open trade drawdowns
which may ultimately be to the detriment of overall
profitability.
There are obviously benefits in knowing your maximum drawdown
based on both open equity and on closed equity only.
So, why shouldn't both be reported by trading system testing software.
Numerous figures of performance evaluation are normally
included in testing summaries and it would not seem
hard to include one more that is particularly important.
That way you would know both the greatest decrease in
open trade equity at any time during the testing time
frame and you would know the greatest decrease in actual
money lost in closed trades.
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