What is drawdown?

The largest drawdown is calculated by keeping track of your built up equity. When losing trades begin to subtract from this equity, drawdown occurs. This is a very important statistic to consider when analyzing a trading strategy. You will never follow a trading strategy which has a strong propensity toward diminishing your equity. There are two most popular ways to calculate drawdown. One is calculated from closed trades only. You can also use the unrealized equity including which includes the proceeds from open trades.

What is a drawdown?Why is it so important?

When backtesting it is very important to research a strategy over as much data as possible. For example, applying a strategy in US stocks to the datar range from 2008 until 2018 can be deceptive. It was a major bull market and the general market indices seldom experienced a considerable drawdown deeper than -15%. So if your strategy had little drawdown it has no predictive value because you didn’t test it on a volatile market 1998-2008, with some solid drawdowns.

Having a strategy which hasn’t been backtested is equal to not having a strategy. Anyone can have a runup for one two or even three years – especially in the past decade. On the other hand, you might still want to take the risk and accept that drawdowns happen.

The old saying “double the drawdown and half the profit” for out of sample trading is not quite true if you have used the right data and method.

When researching a strategy on futures you should always consider and not underestimate the cost of rollovers (and the effect of the long term price chart). When testing on stocks you need to consider the quality of data and survivorship bias. You can read more about it here: Why you should test without survivorship bias

The odds on having an upturn are increasing every day!