No discussion of trading system evaluation would be complete without a discussion of drawdown. We must always look at the maximum drawdown of any trading system as it is very, very important.
The maximum drawdown of trading system is defined as the greatest peak-to-valley drawdown in a trading system’s equity. Let’s say for example that we have a trading system that reaches a particular equity peak of $100,000. Let’s further say that two weeks later, the trading system equity is at $80,000. In this example, let’s say that the $80,000 equity happens to be an equity valley. In that case, the peak-to-valley drawdown would be $100,000-$80,000 equals $20,000. This means that the maximum drawdown is $20,000.
So why is the maximum drawdown such an important measurement in our evaluation of a trading system? It’s because the maximum drawdown gives us a measure of the survivability of the trading system. A simple measure, but a measure nonetheless. Basically, when we look at the maximum drawdown we can say that this maximum drawdown can happen again at any time throughout the life of the trading system. This is particularly important when it comes to evaluating starting account size.
As an example, let’s say that you started to trade the system using an account funded with $10,000. Right off the bat, you can see that this would not be prudent, because as we can see from our maximum drawdown figure if we went into a drawdown immediately after starting our account our account balance would logically be wiped out.
We can see from this quick illustration that we definitely need to fund our account with more money than enough to cover the maximum trading system drawdown. It makes perfect sense to have a buffer of some sort as well.
I would exercise caution, if you are looking a trading system and the recommended account size is the exact same size as the maximum drawdown.
The maximum drawdown is an essential measure that gives us a better idea of what to expect when trading a particular system. A comparison of risk versus reward is an absolute essential in successful trading.
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