Drawdown is an important word. Maximum drawdown is a phrase you will come across very frequently too. As you trade, your equity balance moves around. Every winning trade increases the balance and every losing trade reduces it. Any reduction in the balance is a drawdown.
What is drawdown?
Your system will produce more losses than wins but the losses will be small and the wins will be larger, so it works out that the wins outweigh the losses and your balance grows – that is the theory.
How well the theory is borne out in practice depends on several things – the particular system you use will deliver winning and losing trades in a characteristic way and the size of the winners and losers will depend on your stake – which in turn depends on your attitude to risk.
A bold trader will take bigger risks in return for bigger returns and the opposite applies to the cautious trader. The greater the risk, the larger will be the ‘average loss’ experienced and so drawdowns will be larger when they occur. Strings of losses are the normal pattern and so a number of successive drawdowns can be expected.
The trader’s account must be substantial enough to ride through the losing periods in order to take advantage of the winning trades that will come along to replenish – or more than replenish the trader’s funds.
So attitude to risk and the particular system selected are the major factors affecting drawdown. Provided the trader sticks to his system, he should understand what is going on as his equity balance moves around.
It is important that drawdown does not reduce the account below the planned level and the only way of controlling this is by following the tested plan. Even so, the markets will always behave differently to how they did in the tests and nobody knows what unexpected bonuses or setbacks will be experienced.
The residual uncertainty in the trading operation is what makes the potential returns so attractive but of course there are no guarantees of success.
Traders who employ sound methods are always the ones who produce the major successes by keeping the risk/return balance under control – which means keeping drawdown under control. The drawdown pattern of the trader’s account is a reliable indicator of the level of risk being taken and this must not exceed comfort levels otherwise the trader is unlikely to stick to his system.
As soon as a trader has evaluated a particular system and set the parameters under which it will be run, he has cast the die for likely expectation.
Copyright David Bromley 2006
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