Systematic Trading research and development, with a flavour of Trend Following
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A trick to reduce Drawdowns

April 28th, 2010 · 16 Comments · Backtest, Strategies, Trend Following

Illustration by jared@flickr

Illustration by jared@flickr

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: I 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 with more nuance. We’ll still reduce the drawdwon of a system, but with no magic trick involved.

Obviously, you know that drawdown is the relative distance between the current equity and the highest past equity peak. And when considering using a system with a Max Drawdown of 30%, this is the amount potentially threatening your starting trading capital. 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.

Trend Following induces Drawdowns

By nature, Trend Following is a strategy prone to drawdowns because of the way it waits for the trend to reverse before closing the position. On any winning Trend Following trade, there is often a lot of open equity “given back” to the market.

Below is an equity graph of the life of a hypothetical Trend Following trade:

EquityCurves

The closed equity only changes when the trade is closed out, while the total equity reflects the value of the open position (open equity) added to the closed equity. The non-risk equity represents that portion of equity if the trade hit its stop-loss 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.

Does it make sense to look at Total/Open Equity?

As mentioned earlier, total equity is the universal measure of system performance. You often hear that you should consider the value of open profits (open equity) in the same way as your hard-earned capital and defend it just the same (rather than gambling it away as if it was the market’s money). I do not believe this directly applies to Trend Following, which does not attempt to time tops and bottoms; and enters trades with the understanding that a large portion of each trade open profit will be left “on the table”, but that, on the long run, is the best way to benefit from these trends.

Trend Following’s open profit (open equity) is just potential profit – and as the saying goes:

Don’t count your chicken before they hatch.

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.

Looking at the hypothetical trade example and its associated equity curves, it might not make the most sense to look at your system’s performance through the green total equity curve “lens”. It is arguable whether the open equity and its highest point have much direct relevance to the system result if we accept that letting the open equity grow and subsequently shrink is “part of the game”. 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 is actually made.

Total Equity and System Statistics

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. based on the position size). However, as the trade 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.

In terms of drawdowns, we know that a large portion of the drawdown is actually due to giving back open profits, a necessary “evil” to implement a Trend Following strategy. Drawdown on closed equity is a better measure of 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).

On the winning trade example, this would give drastically reduced drawdown and risk/heat figures.

Real System Drawdown Reduction

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 (50-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):

TotalvClosedEquity

The curves do look similar, however the drawdown figures are quite different, with the Total Equity Drawdown being nearly 35% larger than the Closed Equity one:

  • Total Equity Max Drawdown: 38.2%
  • Closed Equity Max Drawdown: 28.5%

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 28.5%, despite the headline drawdown figure of 38.2% (note: I am assuming that when starting trading a system, one only takes new signals).

In Closing

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 yourself or for potential investors…

PS: in place of “non-risk equity”, used in this post, you might also come across the term”core equity”.

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16 Comments so far ↓

  • Joshua Ulrich

    Very interesting insight, and well articulated.

    I’ve never been a fan of the “you don’t make/lose money until you close the position” idea because it ignores opportunity costs. 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.

  • Eventhorizon

    Agree 100% with your argument here. If you never had the cash you never had the profit!

    Best approach: track open equity AND closed equity.

  • Nick Radge

    Jez,
    Thanks for the insights. I’ve been trading 25-years now and much of it as a trend follower. The issue I see here is that people naturally, and quite possibly incorrectly, view their account equity on any given day as their own and therefore don’t enjoy giving it back regardless of how its accounted for.

    Keep up the good work,
    Nick Radge

  • Motomoto

    A lot depends on how you view “paper profits”
    At the end of the thread you nailed the pertinent point. Who is the end user.
    For clients you have no choice. For yourself it become psychological and personal preference.
    Ideally you want the best of both worlds and varying ways to trade the equity (off total or closed?) and how you measure risk. This is also interesting in terms of elements of profit taking and open heat, and if there are options to smooth there.

  • cordura21

    “The concept of ‘market’s money’ seems to be some sort of psychological palliative, in conflict with the notion of private property. You might consider taking this notion to your Tribe as an entry point. ” (Seykota to Van Tharp)

    Looks like this issue rises a feud or two. In my case, I’ve been conservative and pro-maxDD and cash equity, but I guess I am missing too much. These kind of posts are good thought provoking stuff.

  • Nizar Mahri

    Hi,

    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 via 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 thought this was a good compromise between the two extremes.

    I explained a bit more here. The comment is a good suggestion.

    Nizar.

  • Anon

    This is a good article. Each time I enter a new trade, I record entry price and the stop loss level, i.e. every trade is initially booked as a loss. It’s the right way to do it, as you become much less obsessed with “giving money back” to the market.

    The point about closed equity drawdown being less than regular drawdown is interesting. When I backtest, I incorporate a minimum account balance number, e.g. starting capital 100k, what is the lowest this ever goes starting the strategy from various points.

    What I’ve found is that this “initial drawdown” is usually quite low – in other words, unless you’re seriously unlucky, your account should start to grow fairly quickly. It’s not to say that you won’t have big drawdowns, it’s just that, when you do, they are unlikely to take you much below the initial starting point. In theory!!

  • Saurabh Shah

    +1
    When you begin a trade and you lose out straightaway, due to a stop being hit, what do you consider as your drawdown? zero?

  • Wind

    Good article.
    Have you read something about Constant proportion portfolio insurance (CPPI)?

  • Jez Liberty

    Thanks Wind, I’ll check CPPI out.

  • sagoga69

    Very good Article.

    I agree 100% with your ideas. 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.

    Congrats for the article and for the blog

  • bhanwaar

    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. That is the core part however lot more goes behind a trade (trend, money management, proper entry/exit) which makes a trade successful.

  • Steven

    Dear Jez-

    Just ran across your insightful blog. I have a quick question. The Donchian system (50-day breakout) you showed in this article would have yielded about 35-40% per year. This would be superior to the 17.21% return in your Super Trend Following index. Why did the fund managers not use it? Was it because of transaction cost and market impact? But these factors should have minimal impact on a trading based on 50-day signals, right? Namely, the round-trip trades are not so frequent… Thanks in advance for your insights.

  • Jez Liberty

    Thanks Steven,
    I cannot recall the exact figure or the CAGR of the test on this post. I would be surprised if it was as high as the MaxDD (usually a “standard” TF system achieves MAR of <1). However, it is higher than 17.21%(maybe 30%) , so your question is still relevant.
    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: this will increase return (to a point where it starts getting detrimental – Vince's LSPM book is a good explanation of why, or this post) but also volatility or MaxDD.
    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 it is used ubiquitously in the finance industry…

  • Steven

    Thanks, Jez. Maybe I should rephrase it this way. Since one can scale down the position to lower maxDD (and returns), why 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 100-day Donchian, the number of trades is about 1,200. I guess, for a 15-year period, from 1996 to 2010? The trade duration is about 120 days on average, which means 30 round-trip trades per stock for 15 years. Does that mean you applied it on 1,200/30 = 40 stocks? Why 40 and which index did they belong? I guess you must have stated the setup before, but I joined in late to catch it up… Thanks.

  • Jez Liberty

    Steven,
    You’ll most likely find that these funds have often a better net-of-fees-and-slippage-risk-adjusted return number than most out-of-the box systems.
    CTAs do add value by their research and application in risk management, execution, portfolio selection and other areas. I guess many of their investors prefer to “outsource” this research and trading process rather than doing it themselves. But lots of independent traders follow the other alternative (and I think Trend Following is probably one of the less difficult fund management strategy to replicate – if you compare with heavy maths quant strats, HFT, or discretionary/fundamental analysis approaches).
    I’d recommend these posts for further reading:
    How to measure CTA’s alpha
    CTAs: Are they worth their fees?

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