Trading Systems and Money Management : A Guide to Trading and Profiting in Any Market

MeD Median drawdown

MaD Maximum drawdown

Note, however, that this analysis says nothing about whether any or all of the

different drawdown values fall within tolerable limits in the first place. All this

analysis does is help you decide if the relatively large or relatively small draw-

downs are in minority and considered to be the least expected in the future.

Nonetheless, sometimes you could be better off trading a system with a very

large maximum historical drawdown, as compared to a system with a seemingly

more reasonable maximum drawdown, because you know that the very large his-

torical drawdown was due to a freak occurrence that you expect won’t happen again

anytime soon, which is not the case with the seemingly more tolerable drawdown.

As should be clear by now, the largest drawdown, especially if it’s measured in

dollars, says very little about what you can expect from your system in the future. In

fact, because the drawdown is a function of other system characteristics, rather than

a core characteristic in itself, the best way to come to grips with it is to analyze and

modify these characteristics, instead of trying to modify the drawdown directly.

More specifically, the drawdown is a function of the mathematical expectan-

cy (i.e., the average profit per trade) and the percentage of profitable trades. Table

5.1 shows how it all ties together.

Using the information from Table 5.1 and the DFI, you can analyze the max-

imum drawdown for a system in relation to the core system characteristics before

you set out to trade your way into any unpleasant surprises, or perhaps even start

to trade a system that you otherwise would have discarded because of the high his-

torical drawdown.

For example, if the system characteristics indicate that the system you’re

examining (whether the results are for real or back tested) has a high average prof-

62 PART 1 How to Evaluate a System

Average profit per trade

Low High

Low Many and steep made up of Many and shallow made up of many

many trades trades

Can take time to get out of Usually needs only one or a few trades

to get out of

High Few but explosive and deep Few and shallow, with few trades

Can take time to get out of Easy to get out of with one or a few

trades

TABLE 5.1

Mathematical Expectancy and Percent Profitable Trades

Percent profitable trades