Monday, September 27, 2010

Drawdowns

Drawdowns suck! We all know that. But how you handle them will impact your current and future trading habits.  When I am developing a system, I can use software (Amibroker) to backtest it in order to estimate performance based on a number of metrics. Some of those metrics include maximum trade drawdown and maximum portfolio drawdown.  It gives me an idea of how bad it can get, but until I experience it in real time, I really don't f I can truly handle the decline. I am experiencing a drawdown right now, and by most measurements it is not that severe.  I'm figuring out that the duration of the drawdown is what is just as critical than the % decline itself. What is worse, a 15% drawdown that takes 20 days to recover, or a 7% drawdown that takes  100 days to recover? The 15% is more of a short, sharp pain, where the 7% is a slow burn. The longer it lasts, the more confidence I lose, the more I question the system.  There is a point where I accept the % decline, but the length of time it takes to recover it can be more agonizing.  Inevitably, every trader recovers from their drawdown (if they don't, they go bust), but you deal with the recovery time is just as important as how you handle the decline itself.

1 comments:

piedmonttrader said...

Hello. Just found your blog and I am reading through it. So far I've found some interesting and thought provoking ideas.

Regarding draw downs extensions and duration you pose an interesting question that we system developers certainly tend to overlook. In back testing time it is just so easy going through draw downs in millisecs while in real trading we need to take one 24h day at a time. At the moment my equity curve is going through a drawdown and I am going through a critical review for each one of my systems trying to decide on a rational basis whether I should increase, maintain, reduce or even eliminate (stop trading) risk. My current thinking goes in the direction of comparing current drawdown patterns to back testing in terms of: max number of consecutive losses, max cumulative loss, max drawdown duration. If what I see resembles (as it is currently the case) the past then decision is to continue trading and maintain risk level until either the system recovers or the drawdown pattern is statistically too different to history to assume that the underlying process is still intact. As a corollary I have now learned that one of trading commandments: define your loss before putting on a trade should be extended to system trading in the form: define under which conditions risk should be reduced or eliminated before trading the system live.

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