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Professional traders always want to know: "What is the worst-case scenario?" The maximum amount of money lost is the maximum drawdown. It indicates the minimum amount of capital we would need without liquidity problems. It serves as an indication of what we could lose in a series of losing trades. It also tells us how often a large loss or a series of losing trades may adversely affect our equity. Maximum drawdown is perhaps the best way to determine risk, since risk is defined as the possibility a particular trade or a series of trades could result in a loss of equity. In order to determine the amount of capital required to trade a particular methodology, margin requirements must be added to the maximum drawdown. |
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Real-time drawdown attempts to determine how much equity is required to trade a particular methodology. Real-time drawdown is calculated on a day-to-day basis, based on the daily settlement price. While it takes time and effort to determine drawdown in real time, it is the best way to measure the possible future capital requirements. |
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Always remember that a drawdown of 100 percent means the trader is out of the game. In fact, a drawdown of 50 percent usually means the game is over. Maximum drawdown is a very clear way to determine how well your equity is protected from risk. By determining the maximum drawdown that a trading methodology creates, we can begin to obtain an approximation of the amount of risk our trading capital might be exposed to. The actual drawdown experienced can vary dramatically from theoretical results. |
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The best way to determine profitability of a particular methodology is using the return on investment (ROI) formula to indicate profitability, and measuring risk by using maximum drawdown. When we combine net profit with maximum drawdown as a ratio, we can obtain perhaps the most important ratio in trading: the reward-to-risk ratio. This ratio tells us how much our reward varies with risk. The reward-to-risk ratio will help us to begin to answer several fundamental questions. How much equity is required? And is this a good trading methodology? |
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The reward-to-risk ratio is very straightforward to calculate. Profits over a period of time divided by the maximum drawdown over the same period of time yields the ratio. |
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