Forex

What is maximum drawdown? Why and how do I calculate it?

First, what is maximum drawdown? It is defined as the largest drop of a given asset within a certain time period.

Why calculate it? I've never made it a point to calculate maximum drawdown but I'm going to now. This is my attempt to start looking at more "advanced" money management concepts so I've decided to start with one of the easiest. The reason for calculating maximum drawdown is to measure the riskiness of your trading strategies. It will also give you an idea of how much money you could lose at some indeterminate point in time.

How do I calculate it? During the history of your trading strategy, I'm sure you'll be keeping track of your change in equity from one day to another, one week to another, one month to another, or whatever time period you choose. In the course of your trading, you will calculate drawdown which "represents the total percentage loss experienced by
a strategy before it starts winning again … and drives the
investment balance back up." (Source: http://www.confidentstrategies.com/maximum-drawdown.htm)

In this picture (Source: http://www.autumngold.com/Performance/DescriptionDD.htm), the drawdown is calculated with the following formula:

(Valley VAMI - Peak VAMI) / Peak VAMI

The Valley VAMI is the red arrow or approximately $1,100.

The Peak VAMI is the green arrow or approximately $1,425.

Therefore the drawdown is ($1100 - $1425)/$1425 or -22.8%.

Let's do 1 more example from the picture above. First let's find the Peak prior to the green arrow.

The Peak VAMI is approximately $1,250.

The Valley before the green arrow is at approximately $1,150.

Therefore the drawdown is ($1150-$1250)/$1250 or -8%.

So to find the maximum drawdown, select the drawdown that was greatest, in our example, -22.8%.

Popularity: 10%

I was turned on to an article in the New York titled "Blowing Up" by Rob Booker's blog. According to him, it's the best article he's read in a long time and I have to absolutely agree with him.

The article is about a money manager named Nassim Taleb who created an investment strategy "predicated entirely on the existence of black swans; on the possibility of some random, unexpected event sweeping the markets." Most traders dismiss this black swan as an unlikely event like Victor Niederhoffer who was one of the most successful money managers in the country at one time. Niederhoffer blew up his entire account by selling a large number of options, betting that the market would be quiet. The odds were totally in his favor he thought because the chances of the market going down so heavily were miniscule. Unfortunately for him, the market plummeted 8% in October, 1997 due to the economic crisis in Asia. Niederhoffer made the same mistake again and lost after two planes crashed into the World Trade Center. The black swan reared its head again.

Taleb takes an opposite approach and bets that the black swan will inevitable rear its head and when it does, he will have his payday. In the meantime, he compares the waiting as bleeding a slow death and most days as other money managers are making large sums of money, he's losing small amounts of money.

So as long as you have a definable risk which only threatens a small amount of your capital, you have a chance of riding a wave of profitability that outweighs these smaller losses. I don't want to oversimplify this because it's not easy but it is possible. Weigh your time and be patient. That unexpected event that could wipe out a traders account is right around the corner.

This is definitely worth the read. My summary doesn't give it justice. http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

Popularity: 8%

I've been slowing getting my Forex "legs" back by reading a book I picked up months ago. The Book is called "Trade Your Way To Financial Freedom" by Van K. Thorp. I picked it up months ago based on recommendations from Simon over on his blog. I can see why he thinks so highly of this book because it is so different from the plethora of trading books out there. Van stresses managing reward to risk in your trades and position sizing. I was certainly most interested in his position sizing chapter of which I'll be talking about more in the future.

Poor position sizing can kill your account. Risk too much on any given trade and it could be impossible to recover. I've been down this road before and the reasons for this were inexperience and greed. If you were to open a $1000 trading account and you lose $200 on your first trade, this would be a 20% drawdown. The percentage gain you need to recover from this loss is a possibly manageable 25%. But if you were to lose $400 on your first trade, or a 40% drawdown, you would need a 66.7% gain to recover from this loss. This information may be trivial and known by many, but the extent isn't quite noticeable until you see the following table. Losses beyond 50% require "huge, improbable gains in order to get back to even."

Recovery after Drawdown

Drawdowns, %	Gain to Recovery, %
5	5.3
10	11.1
15	17.6
20	25.0
25	33.0
30	42.9
40	66.7
50	100.0
60	150.0
75	300.0

Popularity: 10%