Sunday, August 28, 2016

A reality check - looking at drawdowns

Quite often I meet or correspond with people who seem to think that they can pull a certain amount out of the market on a regular basis. This is impossible - particularly when using a trend following method. 

Depending on your timeframe and parameters, you can easily go weeks, months or even years before new equity highs are made. Therefore, you will actually spend the majority of your time stuck in a drawdown. 

For a lot of people who may be attracted to the potential overall returns of a method, the reality of what you have to go through in terms of drawdowns (both in monetary and time terms) to achieve those returns can be difficult to accept.

A few days back I saw a post from Peter Brandt talking about this very point.

His post shows his own 'underwater chart' for a 5 year period, along with the same for some other successful trading firms over the same term.

For my own trading, I've kept track of my drawdowns and my Calmar ratio, but haven't created underwater charts - until now. 

The graphs below express drawdowns both in percentage returns and also in units of R. This is because, if you trade over a long period of time, your risk per trade in monetary terms can significantly change. However, your percentage of equity risked can remain the same, and therefore one unit of R (being the risk taken on a trade) stays constant:

My own figures are based purely on closed trades on a week by week basis - in other words, any open profits are not taken into account, as they may disappear if price turns against me.

The presentation by Dr Robert Frey which Brandt refers to (and which is essential viewing) talks about how traders can expect to spend 80% of their time in a drawdown, and 67% of the time in a major drawdown of greater than 20%.

On this basis, the above charts show nothing too surprising. Particularly with trend following, losing trades are cut short and winning trades are left to run as far as possible. It is therefore not unusual to expect that one winning trade can potentially cover a whole load of small losing trades, and leave some profit left over.

This explains why a drawdown can grow gradually, before the recoveries can be sudden when those big winning trades are finally closed.

There are a lot of people who participate in the markets who seem to think they should be immune from suffering decent sized drawdowns (or in some cases, suffering losing trades at all!). As soon as they encounter a run of losses, they are off looking at a different method. However, the above graphs show the realities of trading.

You must therefore expect lots of losing trades, and to spend a high proportion of your time in a drawdown situation. If you are unable to accept that, then you are deluding yourself.

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