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How to analyze drawdowns correctly


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How to analyze drawdowns correctly

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  #1 (permalink)
Jersey City, NJ
 
 
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Fellow Futures Traders,

I am developing a fully automated strategy trading stock index and other futures. It holds positions from a day to some months, and it experiences some significant equity drawdowns.

I'm trying to figure out how to think about the max intraday equity drawdown (intraday; not trade close to close) and what is a tolerable $ and % for it.

How should I think about required trading capital vs. max intraday equity drawdown? Should I presume such a drawdown may occur on day 1 that I switch on the strategy and have at least the amount of the drawdown (or double/triple that amount, counting that the worst time is yet to come) of capital in the account, plus required margin, plus capital to purchase the instrument?

Any other rules of thumb related to max intraday equity drawdown vs net profit generated?

Separately, how do people use the trade close to trade close drawdown figure?

From risk management perspective, I understand that the industry standard is to assume that max drawdown in live trading could be double or triple compared to backtesting/simulation trading to account for worst case scenarios.

I also understand that the psychological aspects related to drawdown are significant -- you may be inclined to shut down your strategy if the drawdown is too large to stomach, even if it didn't otherwise pose a restriction on capital requirements.

Thanks for your insights!

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  #3 (permalink)
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Here are a couple of thoughts to ponder as I believe max dd is a personal question.

How deep in the red could you be and still have faith in your system?

How are you going to feel when you're down 20%? 50%?

Another aspect to consider is duration of drawdown. I've been through a couple of flash crashes that happen fast and recover fast. The intraday drawdowns were deep but didn't weigh on me psychologically nearly as much as a long and drawn-out correction would have.

How long are the longest drawdowns in your backtest and how would you feel enduring them?

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  #4 (permalink)
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I've been looking at excursion numbers recently. This is comprised of the maximum and minimum movements of an instrument after a theoretical position is taken.

The two tables below show the QQQ simple moving average situation on Oct 9 and the most recent one ending Nov 11. All numbers are based on a $10,000 investment in each of the conditions. The left side is the situation at the End Date (top middle). The right side is a summary of activity in the above or below states between the Start and End Dates.





Tmm is the total range between the max and min. Pmm is the percent of the range that the current price (based on the start and end dates) is at. The right side shows average numbers, which by their nature, can be misleading due to the ABnormal distribution of price activity.

DMax, DMin, and DTmm gives the standard deviation of the AMax, AMin,and ATmm numbers.

In states where the price is above the given average, DMax tends to be high and DMin tends to be low. The opposite is true for below states.

Might be a good place to start the analysis from.

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  #5 (permalink)
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One good way to analyze trade risk to reward ratio is to look at the maximum DD during the trade compared to maximum profit during the trade.

I think DD should be measured in relation to potential or actual rewards.

Theoretical risk to reward ratio = maximum profit during the trade/maximum DD during the trade

This should obviously be greater than 1.

I'm algo trader myself and this simple method is from Kevin Davey.

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  #6 (permalink)
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My 2 cents:

The reliability of the maximum drawdown you are using also depends on the length of your simulation. The more data you use, the bigger this DD max will be.

To calculate the max DD I use the biggest loss over 1 or more consecutive losing trades not limited by period. You can also do Monte Carlo simulating to get an even more reliable max DD estimation for your system.

For my simulations Iíd prefer to use 1000+ days and prefer to keep my funding at least 2 times this max DD.

Another factor to evaluate your system is to measure how long you expect it will take to recover from a max DD. If your max DD is USD 12000 and your monthly expected profitability is 1000 would you be willing to wait 12 months to recover from your max DD?

I think you should include the possibility that you hit max DD on the first day. The odds are not that big, but it is a question of long-term risk management and leverage. When you start trading your system itís a good idea to start small and only scale up when profitable.

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  #7 (permalink)
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kirahvi View Post
Fellow Futures Traders,

I am developing a fully automated strategy trading stock index and other futures. It holds positions from a day to some months, and it experiences some significant equity drawdowns.

I'm trying to figure out how to think about the max intraday equity drawdown (intraday; not trade close to close) and what is a tolerable $ and % for it.

How should I think about required trading capital vs. max intraday equity drawdown? Should I presume such a drawdown may occur on day 1 that I switch on the strategy and have at least the amount of the drawdown (or double/triple that amount, counting that the worst time is yet to come) of capital in the account, plus required margin, plus capital to purchase the instrument?

Any other rules of thumb related to max intraday equity drawdown vs net profit generated?

Separately, how do people use the trade close to trade close drawdown figure?

From risk management perspective, I understand that the industry standard is to assume that max drawdown in live trading could be double or triple compared to backtesting/simulation trading to account for worst case scenarios.

I also understand that the psychological aspects related to drawdown are significant -- you may be inclined to shut down your strategy if the drawdown is too large to stomach, even if it didn't otherwise pose a restriction on capital requirements.

Thanks for your insights!

Personal preferences here:
max drawdown of 35%
would need to see more testing results to see possible returns?
what account size would be required?
how long was the drawdown in backtesting?
slippage and commissions applied?
Last but not least...as they say when it comes to systems...the worst drawdown is still ahead of you.

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  #8 (permalink)
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kirahvi View Post
Fellow Futures Traders,

I am developing a fully automated strategy trading stock index and other futures. It holds positions from a day to some months, and it experiences some significant equity drawdowns.

I'm trying to figure out how to think about the max intraday equity drawdown (intraday; not trade close to close) and what is a tolerable $ and % for it.

How should I think about required trading capital vs. max intraday equity drawdown? Should I presume such a drawdown may occur on day 1 that I switch on the strategy and have at least the amount of the drawdown (or double/triple that amount, counting that the worst time is yet to come) of capital in the account, plus required margin, plus capital to purchase the instrument?

Any other rules of thumb related to max intraday equity drawdown vs net profit generated?

Separately, how do people use the trade close to trade close drawdown figure?

From risk management perspective, I understand that the industry standard is to assume that max drawdown in live trading could be double or triple compared to backtesting/simulation trading to account for worst case scenarios.

I also understand that the psychological aspects related to drawdown are significant -- you may be inclined to shut down your strategy if the drawdown is too large to stomach, even if it didn't otherwise pose a restriction on capital requirements.

Thanks for your insights!

Hi,

I am not sure that I fully understand what you are trying to do, but you say Intraday ( as with in or during the day in my understanding of the word) and you say you stay in a trade "for a day or up to some monthsĒ - So why are you concerned with the intraday drawdown when you are in a trade for month there will most likely be several days in a row that goes against you trade - if you system is trend-based I would say you will have anywhere from 3-7 days against you with the trend direction still intact.

If you question relates the drawdown of you finds/account this will most likely depent the winning per cent of your system. Letís say you system is a 50/50 system ( same amount of winners and lossers) After 50 trades you will have had experienced a losing streak of 6 trades after 500 trades the figure will be 9 losing trades in a row and after 1000 trades 10 trades.

I would suggest taking you largest losing trade and multiply with 10 - this is what you should expect and have the ability to trade after this. - But it is very difficult to came back at a 10-trade losing streak if the this courses a large draw down in you fund, hence it should not account for absolute maximum 25% in my idea but preferable much less.

If you only risk 1% per trade a 10 losing streak will set, you back less than 10 of you equity high. for you starting point if you start out with the worst losing streak.

But this is only my suggestion,

TraderMich

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