The Drawdown - Prashanth K

Drawdown is a statistical function that is missed by many and worse mis-interpreted by many others. Every system builder always has one eye on the CAGR and another on drawdown. It is a balance that is often unstated but has to remain rational for any system that has been developed after much effort to become operational.

A 1000 percent return with a 90-percent drawdown is a lot worse than a 100 percent return with 9 percent drawdown, although mathematically both are similar. The reason I say that the second is more important is because there is something we call: "Your worst Drawdown is yet to come", which in efffect means that no matter what percentage your system backtest would show, the chance is greater that a drawdown greater than this would arise in real trading.

Secondly, the system does not consider the psychological profile of the trader. It is tough to live with a trade where you have lost nearly 10 percent of the capital as against living in a trade where you have lost nearly all of the equity.

So, lets look at what a drawdown is and why, in my opinion, it is one of the most important figures to see in any backtest.

An Amibroker Backtest report provides two drawdown figures. They are (copy-pasted from AB Help),

Max. trade drawdown - The largest peak-to-valley decline experienced in any single trade.

As explained, it is the drawdown an open trade experiences. For example, assume your system has gone long in ABC at Rs 100 and the stock, after moving to 102, has moved to 96 without there being any additional signal.

The Trade drawdown in this case will be 6 * Qty (102 - 96 = 6).

Max trade % drawdown - The largest peak to valley percentage decline experienced in any single trade .

The above example expressed in percentage terms.

Max system drawdown - The largest peak to valley decline experienced in portfolio equity

This statisic is bit different, in the sense instead of taking a single ticker, it takes the equity as the ticker and provides the drawdown static.

Max system % drawdown - The largest peak to valley percentage decline experienced in portfolio equity.

Same as above expressed in percentage terms.

System Drawdown is useful to know since sometimes systems go into multuiple losses and the equity line plunges dramatically. For example, a system equity after reaching say 10,000 starts having loss trades (consecutively) and reaches 8000, this change would be shown here.

The system drawdown is a important factor to consider when deciding the capital requirement for the system, since if you are using leverage, a large system drawdown can ensure that you no longer can trade with the amount you have in hand and hence all permutations and calculations can go awry.