it per trade and a high number of profitable trades, but also a very high DFI, you
can conclude that the maximum drawdown most likely was a freak occurrence that
will not repeat itself in the near future. On the other hand, if both the average prof-
it per trade and the number of profitable trades are low, and are also combined with
a low DFI, you can conclude that no matter the actual size of the drawdowns expe-
rienced so far, you’re lucky to still be in the game and should not trade this system
for another day. Note also, that in the first example I use the words “most likely.”
This is because, no matter how rigorous your testing has been, there are no guar-
antees. As already stated, every drawdown will be surpassed at one time or anoth-
er. All we can do is to make the likelihood of that happening tomorrow as small as
possible.Types of Drawdown
The drawdown should by no means be neglected completely, but in researching,
you need to know what it is you are doing and what it is you are investigating. For
one thing, the estimated largest drawdown holds valuable information about how
large your account size must be and can give you an indication of whether you
have the psychologic profile to trade the system in question. The several differ-
ent types of drawdowns all need to be dealt with in a different manner. I have dis-
cussed these in detail in Trading Systems That Work, so I will only touch on this
subject briefly here.
Aside from not putting the drawdown in relation to the market situation at the
time, another major error most system designers make when they are building and
evaluating systems is to look only at the overall total equity drawdown(TED),
which is calculated using both the open trade profits and losses, and the already
closed out equity on your account. However, to fully investigate the drawdown, we
also need to divide the TED into several subcategories, namely the start trade
drawdown(STD), the end trade drawdown(ETD), and the closed trade drawdown
(CTD). To understand why, look at Figure 5.2 and follow along in the following
example:
Let’s say that you currently don’t have any positions on and that your last
trade was a $3,000 winner that also took your account to a new total equity high
of $10,000. But before you managed to exit the position, it gave back $1,000 of its
open equity, so that your equity currently stands at $9,000 (day 0 in Figure 5.2).
According to most analysis packages, this means that, even though you managed
to add $3,000 to your closed-out equity, you now are $1,000 in the hole when
compared to your latest total equity high. Furthermore, if your next trade turns out
to be a loser, that immediately stopped out with a $4,500 loss, your closed-out
equity now is $4,500, and your drawdown is $5,500 (day 1). If you then have a
$5,000 winner which, before it took off started out going the wrong way with an
additional $1,000 loss (day 2)—at which point you would have been $6,500 in theCHAPTER 5 Drawdown and Losses 63