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For example, if a trading methodology over a certain period of time generates a net profit of $5000, and the maximum drawdown is $1500, then the reward-to-risk ratio is: |
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To obtain a percentage, multiply the number by 100. |
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In other words, a trader would be risking $1 to obtain $3.33. However, maximum drawdown does not encompass the total risk that a trader's equity is subjected to. This is because of unavoidable and uncontrollable risk factors. Consequently many professional traders multiply the maximum drawdown by a multiple amount to obtain a more realistic indication of the amount of money that could be required trading a particular methodology. So for purposes of illustration we could multiply the maximum drawdown of $1500 by 2. This gives us the following: |
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As you can see, this changes the overall perception of the profitability of a particular methodology. In Figure 18-4 our reward-to-risk ratio is 1.58 to 1 (using a drawdown factor of 2). |
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Here is another example, using two different trading methodologies. The first methodology has an equity curve that steadily increases with small gains and small drawdowns. The second methodology has large gains as well as large drawdowns. However, at the end of 12 months both methodologies have a profit of $6000. The first methodology has a maximum drawdown of $1000; the second methodology has a maximum drawdown of $3000. By using drawdowns as an indication of risk, we can see that the second methodology is three times more risky than the first. If we take into account uncontrollable risk factors, and multiply the drawdown of both methodologies by 2, we can obtain a more clear understanding of the actual reward-to-risk ratio. |
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