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.
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:
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.
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.
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.
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):
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:
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).
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”.