Define drawdown in forex

Drawdowns represent the scary part of trading system statistics. The drawdown number emphasises the level of loss you might suffer while trading that system. It is risk to your trading capital.

Now, for a quick disclaimer: Define do not have a magic trick to simply reduce drawdowns… but with this cheeky title, I wanted to draw your attention to how you can interpret drawdowns forex more nuance. Obviously, you know that drawdown is the relative distance between the current equity and the highest past equity peak. Well, not necessarily so…. It all depends what you consider your capital and what equity you use to measure your drawdown. Total equity is the universal measure in terms of reporting including drawdown figures.

It is made up of both closed and open equities. Closed equity is your account balance after taking into account the starting balance and all closed trades.

Open equity is the value of all open positions. By nature, Trend Following is a strategy prone to drawdowns because forex the way it waits for the trend to reverse before closing the position. The closed define only changes when the trade is closed out, while the total equity reflects the value of the open position open define added to the closed equity.

The non-risk equity represents that portion of equity if the trade hit its forex and was closed out, effectively representing the locked-in equity from the trade. As we enter the trade, the locked-in equity is negative stop-loss below trade entry price but as we gradually raise the stop-loss level or as the indicator used for the exit signal moves up the locked-in equity becomes positive. When the trade ends, the three equity curves meet again.

As mentioned earlier, total equity is the universal measure of system performance. It might be cautious to do the same thing with your trading system, and not bank on the open equity, or treat it the same way as actual, realized profits.

The open equity does not directly affect the bottom line. What matters is how much of our capital closed equity we risk, and how much profit forex actually made. On the equity curves chart, representing only one winning trade, the relatively wide variations in open equity impact some system statistics:.

Despite the fact that the trade never loses more than half the initial risk, it leaves us with a drawdown of three times the initial risk percentage. Also, of interest, to monitor the risk taken, is the system heat.

The typical heat calculation is the amount of equity at risk, basically the difference between the total equity and the non-risk equity. Every time we open a new trade, the heat is equal to the initial risk taken for that trade ie. However, as the define progresses, the heat increases to multiples of that amount, despite the real initial risk being unchanged. Looking at raw drawdown and heat numbers from a total equity point of view would give a false impression of the actual dynamics of the system, which seems penalized for what is, in essence, a good Trend Following trade.

It could be argued and I do that looking at alternative equity curves might give a clearer picture. Drawdown on closed equity is a better measure define how the system is going wrong by actually taking losing trades, and of how much capital might really be lost when trading the system.

Similarly, for the risk currently taken by the system, you might want to measure the heat by comparing closed equity to non-risk equity. The heat being the difference between the former and the latter ie equal to the opposite of the locked-in equity when negative, zero when positive. This is all well and good in a single theoritical trade example, but how does this actually affect a real system?

To check this, I fired up Trading Blox and ran a standard Donchian system day breakout and calculated MaxDD on both total and closed equity curves. First, here is the chart of both curves. As expected they roughly follow the same path, spreading apart and joining again regularly — but they never diverge for too long and never will:. Would you have started trading this system at any time in the past, you could not have incurred a loss to your starting capital of more than I am assuming that when starting trading a system, one only takes new signals.

I am sure this is a controversial point of view amongst trading system designers and total equity is necessarily the one to look at for accounting, tax and fund reporting reasons. This post is not really advocating one way of measuring system performance over another but draws the attention to interpreting the right statistic for the right characteristic, when designing and monitoring your trading system.

Now, it also depends whether you are designing a system for drawdown or for potential investors…. However, I do agree that looking at drawdown on closed equity seems to give you a better idea of the capital required to trade a system.

Jez, Thanks for the insights. Who drawdown the end user. For clients you have no choice. For yourself it become psychological and personal preference. Ideally you drawdown the best of both worlds and varying ways to trade the equity off total or closed? This is also interesting in terms of elements of profit taking and open heat, and if there are options to smooth there.

You might consider taking this notion to your Tribe as an entry point. Looks like this issue rises a feud or two. These kind of posts are good thought drawdown stuff. Because of the differences in open and closed equity when trading long term trend following systems, the way you position size becomes important.

When I used to trade stocks forex longterm trend following, I used to define equity for position sizing purposes as my cash in the bank plus open position at their trailing stop position.

I explained a bit more here. The comment is a good suggestion. This is a good article. Each time I enter a new trade, I record entry price and the stop loss level, i. The point about closed equity drawdown being less than regular drawdown is interesting. When I backtest, I incorporate a minimum account balance number, e. Have you read something about Constant proportion portfolio insurance CPPI?

Usually, people see those maxDD with open positions as a system design fault, buy the truth is that those DD are inherent in the trend-following approach. If anyone making profit that individual must be following trend what ever time-frame that person is trading. When someone loses money must have traded counter trend.

Just ran across your insightful blog. I have a quick question. This would be superior to the Why did the fund managers not define it? Was it because of transaction cost and market impact? But these factors should have minimal impact on a trading based on day signals, right?

Namely, the round-trip trades are not so frequent… Thanks in advance for your insights. Thanks Steven, I cannot recall the exact figure or the CAGR of the test on this post. However, it is higher than You cannot really compare raw returns to derive the performance of two different investments. You also have to take into account risk ie risk-adjusted return.

Since return is a function of leverage, it is quite easy to "turn up the heat" in any system by adding more leverage: Going back to that example on the "Super TF Index", the MaxDD is much lower than in the test in this post.

A fairer comparison would be to normalize both for leverage so that either MaxDD or return figures are equal. Of course, the Sharpe ratio also takes some of these concepts into account and is probably why drawdown is used ubiquitously in the finance industry…. Maybe I should rephrase it this way.

Since one can scale down the position to lower maxDD and returnswhy would one bother to invest at all at these funds? Why not just use the Donchian breakout system oneself? In other words, what are the values added by these fund managers? Thanks for your insights. I ran across your blog just yesterday to catch up with many details in the setup of some of your backtests. For example, in your discussion of slippage 3 with day Donchian, the number of trades is about 1, I guess, for a year period, from to ?

The trade duration is about days on average, which means 30 round-trip trades per stock for 15 years. Why 40 and which index did they belong?

I guess you must have stated the setup before, but I define in late to catch it up… Thanks. CTAs do add value by their research and application in risk management, execution, portfolio selection and other areas.

Are they worth their fees? You can use these tags: Notify me of followup comments via e-mail. Sy blog, Systematic Trading research and development, with a flavour of Trend Following. Past performance is not necessarily indicative of future results. Futures trading is complex and presents the risk of substantial losses; as such, it may not be suitable for all investors. The content on this site is provided as general information only and should not be taken as investment advice.

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Drawdown ideas expressed on this site are solely the opinions of the author. The author may or may not have a position in any financial instrument or strategy referenced above. Any action that you take as a result of information or analysis on this site is ultimately your sole responsibility. Sy blog — Automated trading System — Sitemap — Powered forex Wordpress.

Sy blog — Au tomated Tra ding Sy stem. Wisdom Tradinga Futures Broker who can Execute your Trading System and provide access to Global Markets and CTA's — all at great rates. Sy recommends CSI Data. Illustration by jared flickr. If you never had the cash you never had the profit! Keep up the good work, Nick Radge. I drawdown this was a good compromise between the two extremes.

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