Drawdowns and Persistency

Drawdowns

A drawdown is the difference between your maximum capital and your capital at a point in time after this maximum has occurred. Let’s start with an example.

Imagine you start with £5,000 and have a brilliant few months of trading and turn this into £10,000, then your account drops to £7,500. Your maximum capital was £10,000 and you are currently at £7,500 which equates to 25% less than your maximum value. Therefore, you are at a 25% drawdown. Simple as that.

Drawdowns are an unavoidable part of trading and result from a combination of losing trades and the natural fluctuation in profit on open trades. Nonetheless, drawdowns are the most difficult period of trading by a clear mile. The unfortunate truth is that you will spend the majority of your time in a drawdown in some way, shape or form. Your portfolio will go through periods of making new highs, but these are always followed by a drawdown. There is no exception to this rule. A system with no drawdowns would need to win 100% of the time, which is not possible.

Drawdowns result from the natural distribution of positions and market cycles. Imagine a system that has a 40% win rate, where the average winning position is double the average loss. Over a period of 10 trades, it is not always going to be 4 winners and 6 losers. It could be 10 losers in a row, it could be 10 winners, or anywhere in between. Similarly, the winners may be small, or you could have the biggest trade of your life. You can’t know until those trades are over. This is what causes drawdowns, and it’s important to maintain consistency and discipline when this is happening.

Check out the chart below for an 80% compounded annual growth rate trend-following system. The black line shows the equity curve and the orange line shows the corresponding drawdown at any given time. When the orange line goes to zero(see axis on the right-hand side of this chart), the equity is making new highs, otherwise the account is in a drawdown. It shows clearly that drawdowns are frequent and can be long, sometimes occurring nearly a year before the account breaks up to new highs.

This is a snippet of what you can expect to experience if you are to be a successful trader. The worst drawdown for this example in this period is in 2003 and shows a 60% drawdown. In the 2001-2003 period, the equity moves from £10,000 to £112,000 then back down to £60,000. Obviously, this is an incredibly mentally challenging period to watch £50,000 leave the trading account. However, this is the same system that initially made £100,000 in the period prior to the drawdown, so it is important to maintain perspective.

The market equity profile doesn’t reach new highs (above £112,000) for another 18 months, after which there is a period where it goes up to £500,000 almost unhindered.

Drawdowns are the period in which most traders will face the biggest challenges, and where most traders give up. Good money management is crucial in order to be able to manage drawdown size so they don’t blow your account (More on this in the money management guide). During a drawdown you a likely to doubt the trading system and question any results from testing. You will question whether the system still works, whether the testing results were an anomaly and for many they will stop trading as a result. People tend to stop just before the system kicks off again, and they miss out on the profitable period entirely. This is why you must continue to trade through a drawdown and follow your trading plan consistently.