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Two Popular Ways To Report Max Drawdown - One Is Much Easier To Take
Maximum drawdown is a very important figure which is normally reported as one of the factors in analyzing a trading system by historical testing software. It is generally defined as the greatest decrease in equity at any time during the testing period under consideration and it is usually reported both in terms of actual dollars and as a percentage.
Only recently have I begun to realize that various testing software programs differ in how they report this figure. The two biggest variations seem to center around whether or not the maximum drawdown figure is based on closed trades only or on both open and closed trades.
Open and closed trade calculations: When maximum drawdown is based on open and closed trade equity it will tend to vary every day that any trades are in progress. The benefit of this figure is that it monitors daily fluctuation in equity throughout a trade or a portfolio of trades. The limitation of figure is that it counts losses of open profits as actual losses.
For instance, let's say you are trading a system and you currently have open trades in 4 markets: JY, SF, BP and DX. All the financial markets are moving well and you have a current open profit of $5,000 per market or $20,000 total. Then, as it often happens, the markets move against you and your long-term system doesn't get you out until you have lost half of your open profit. So, you exit the 4 trades with $10,000 in profit. This would be common of many long-term systems which allow a market to move a large amount against you before exiting the trade as a trade-off for giving the market room to stay in the major moves.
The problem is that these 4 profitable trades will be reported as a $10,000 drawdown since you had a $10,000 loss in open equity. If this period were immediately followed by an extended period of closed trade losses totaling $10,000, those total losses would be added to the previous open profit drawdown of $10,000 to arrive at a new figure for maximum drawdown of $20,000. In this case half of the maximum drawdown figure would represent actual closed trade losses and half would represent decrease in open trade profits.
Closed trade calculation only: When maximum drawdown is based on open and closed trades it will only vary when your system exits a trade. The only factor taken into consideration is the affect of actual closed profits and trade losses.
The limitation of this figure is that it does not tell you anything about open equity when you are currently in trades. The benefit is that it reports the important maximum drawdown figure only on the basis of actual losses.
Let's look again at our above example where you were currently in 4 trades in 4 currency markets. In that scenario the system would report a $10,000 profit and 0 drawdown since you actually made money upon exiting the trades and you did not actually lose any money.
Personally, I am more interested in knowing the maximum drawdown based on closed trades since that tells me the greatest decrease in capital I could have had if I had started trading at the worst possible time, although it's true, drawdown figure will change even over the same testing period depending on when you start the test.
There is a vast difference in going through a drawdown of $20,000 in actual capital and in going through a $20,000 drawdown in open profits that ultimately ends up as a profitable trade. Also, there is a big difference psychologically.
My complaint with reporting maximum drawdown as a percentage is that it is usually based on the greatest percentage decrease in equity at any time during the testing period. This would often include equity based on open and closed trades which I have already given my opinion concerning.
The other problem here is that it is a figure that is based on the current equity which begins as the initial start-up capital and by design it will almost always identify the greatest decrease in equity by percentage to be in the earlier years of a test. This stands to reason since equity will generally increase over time with a profitable system.
If you begin with $50,000 in capital and immediately have a $20,000 drawdown, then that number represents a 40% drawdown. However, if you initially have some profitable trades and ultimately double your capital to $100,000, the same $20,000 drawdown now only represents a 10% decrease of your capital. It ends up telling you more about how early in the testing period a drawdown occurred than how large it was.
Personally, I'd rather see this percentage refer to the same maximum closed trade drawdown period which the dollar figure drawdown refers to. My own spreadsheet calculations, if correct, indicates a closed trade max drawdown will often be much less than open trade max drawdown.
One system I compared had an open trade maximum portfolio drawdown of approximately $47,000 and a maximum closed trade portfolio drawdown of approximately $39,000 or 17% less. Another trading system had a open trade maximum portfolio drawdown of approximately $36,000 and a closed trade maximum portfolio drawdown of approximately $16,000 and represented an equity drawdown which was 56% less.
The difference in these numbers could make the difference in a trader deciding whether or not to purchase or trade a system. Also, the method of calculation of maximum drawdown based on open trade equity might tend to encourage system developers to design long-term systems to exit trades quicker in order to limit open trade drawdowns which may ultimately be to the detriment of overall profitability.
There are obviously benefits in knowing your maximum drawdown based on both open equity and on closed equity only. So, why shouldn't both be reported by trading system testing software.
Numerous figures of performance evaluation are normally included in testing summaries and it would not seem hard to include one more that is particularly important. That way you would know both the greatest decrease in open trade equity at any time during the testing time frame and you would know the greatest decrease in actual money lost in closed trades.