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Confused on the definition of drawdown?


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Confused on the definition of drawdown?

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  #1 (permalink)
Greensboro NC
 
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I had a random thought of Friday after seeing another post. My question stimulates from the term drawdown, we all would assume this is when you have a run of bad trades, correct. I can see this holding true more with a mechanical system, hence the market just isnt in your systems sweet spot so you encounter losses. But if your system is based off of your experience of reading the market you should only en cure a few losses before your mind adapts and you adjust your trading to it.

Looking forward to your thoughts guys, because behind this question applies money management. Ie. if you can overcome drawdowns in quick enough real time to minimize losses, then one could actually trade a larger percentage of his account and grow it quicker or not?

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  #3 (permalink)
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Rad4633 View Post
I had a random thought of Friday after seeing another post. My question stimulates from the term drawdown, we all would assume this is when you have a run of bad trades, correct. I can see this holding true more with a mechanical system, hence the market just isnt in your systems sweet spot so you encounter losses. But if your system is based off of your experience of reading the market you should only en cure a few losses before your mind adapts and you adjust your trading to it.

Looking forward to your thoughts guys, because behind this question applies money management. Ie. if you can overcome drawdowns in quick enough real time to minimize losses, then one could actually trade a larger percentage of his account and grow it quicker or not?


A drawdown refers to a series of trades. The drawdown is the worst outcome of any subset of consecutive trades, or otherwise put the longest down leg of your equity curve, which connects a relative high to a relative low. The drawdown should be expressed in absolute value, if you use a constant position size. It should be exrpessed in percent if you follow a fixed fractional approach.

If you are a discretionary trader, that is a trader who does not strictly folllow a set of rules but follows his guts, then the drawdown does not mean a lot.

If you follow a mechanical system derived from a set of rules, then the maximum drawdown is an indicator of the quality of this system and can be used to determine position sizing or leverage. However, I would not simply use the drawdown of a series of trades, but rather create a Monte Carlo simulation - that is selecting trades from that series by using a random generator - to determine the maximum drawdown, and then calculate the position size from all the drawdowns resulting from the Monte Carlo simulation.

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  #4 (permalink)
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The market is a bit like herding cats, it is not as easy as it looks and you do not learn, because that is just when it changes on you.
Here look at this:
4 Types of Trades | Real-Time Trading Ideas @MissTrade
If you study it you will see that before the final pattern comes out many things look the same and you need to learn from experience what pattern is coming. For example if a head and shoulders does not finish it becomes a double top.
Trends and "revision to the mean" are obvious with hind sight, but require opposite strategies to trade.
For example if you look at this chart
SPY - SharpCharts Workbench - StockCharts.com
you would say the market is in a range, if you trade this market with Bollinger Bands you will make a bundle. Ah but very little in this chart will warn you that the market was about to break out and run up -- but it did.

Prediction is very hard, especially about the future - Yogi Berra

There is a very true adage: "You can beat a horse race, but you can't beat the races. So it is with market operations. There are times when money can be made investing and speculating in stocks, but money cannot consistently be made trading every day or every week during the year. Only the foolhardy will try it. It just is not in the cards and cannot be done -- Jesse Livermore

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  #5 (permalink)
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Hi Rad4633, an interesting notion, thanks for raising it.

I'd agree with FatTails in that without a decent period of testing which includes Monte Carlo runs, you do not really understand approximately what may or may not happen in the future. If your Monte Carlo engine tells you have a 5% chance of encountering 13 losers in a row you are better armed to encouter such a run of losers when it actually happens - and of course allocate your capital in order to protect it.

If you trade manually then you have the additional variable of what is going on in your head. If that means straying too far from your rules, validity of any testing done based on those rules is going to be diluted. Your question is about discretionary traders being able aware of, and then adjusting to, periods of drawdown to be able to overcome them and increase risk. I'd say that it is exactly at such times that trust in a system (where such trust is based on solid testing) will allow a trader to make objective choices, without that platform decision making can quickly become subjective.

So nice to think that in a period of unexpected drawdown (and aren't they always unexpected!) a discretionary trader could think their way calmly out of it. It's certainly a skill I would like to add to my toolbox.

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