To come to grips with drawdowns, we need to put them in relation to both the equi-
ty peaks preceding them and the value of the market at the approximate time of the
drawdown.
But even more important, we need to understand that the drawdown is not a
main system characteristic, but rather a function of the average profit per trade and
the percentage of profitable trades. By focusing on these numbers and making
them as high and as robust as possible, we’re also minimizing the risk for any dev-
astating drawdowns. It is, therefore, important to get a feel for the number of win-
ning and losing trades in a row that a system is likely to encounter and how likely
it is for a similar sequence of trades to happen again.
However, boosting these and other performance measures to sky-high levels
isn’t necessarily a good thing either. Instead, we need to work with numbers that
are reasonable, when compared to other investment or trading opportunities and
the way the market actually behaves. For example, a system with a profit factor of
two and 50 percent profitable trades also has a return of 50 percent on the total
capital risked, whereas a system with a profit factor of 1.5 and 33 percent prof-
itable trades has a return of 33 percent on the total capital risked. For two systems
to produce results like this, they need to have initial risk–reward relationships,
going into their trades, of 2:1 and 3.5:1, respectively.
If we compare these return numbers with other investment opportunities and
the way the market behaves, we realize that this is as good as it will get, and that
looking for systems with higher profit factors results in impossible initial
risk–reward relationships. If the initial risk–reward relationships aren’t sustainable
in the long run, the future performance of the system will plummet. This might
result in a system that still produces a decent profit factor, but has other system
characteristics making it untradable, such as an unreasonably high percentage of
losers and a high standard deviation to the outcome of the trades.
Tying all the above together and making an analogy with the animal king-
dom, it probably is fair to say that most of us would like to trade a system behav-
ing like a cheetah—a mean, lean, killing machine. However, because the cheetah
is too dependent on its environment for its survival, trading a system that behaves
like a cheetah is not a good idea, because even small changes in its environment
will lead to its extinction. Instead, a trading system should behave like a cockroach
that can live and eat almost without concern for the rest of the world.
In trading system terms, the system should function equally as well on aver-
age over as many markets as possible, grinding out small profits wherever possi-
ble and staying afloat during tougher times. Granted, there is little sex appeal to
such a system. But it isn’t your trading that should be sexy, but rather the lifestyle
you can afford because of it.78 PART 1 How to Evaluate a System