Dealing with Drawdowns trading a system, a case study

Now Drawdowns are not what traders want to hear or even think about. But it’s a very important one and it’s what you should think about before starting to trade. What can go wrong? What kind of pain will you have to endure? Can you make it through that?

To make this more concrete let’s look at a specific example. The Natural Gas Future is one of the favorite markets of Ambush Traders. And so for a good reason. Its performance has been very stable over the years and drawdowns tend to get recovered quickly.

But even trading Natural Gas there are times when it can get bumpy trading Ambush. And as we just experienced one of these periods at the end of 2016, I thought this might be a good time to have a look at some statistics regarding Drawdowns.

Let’s start with the equity curve. First of all, the results here assume we’re trading one contract all the time, pay $5 commissions per round-turn and get 1/2 tick slippage on any non-limit order.

On the chart every new equity high is marked red and as you can see we just made new all time equity highs in NG. Another thing to notice is that new highs happen quite often compared to other strategies. During 2016 we had a huge draw-up period making lots of new equity highs.

One of the most useful metrics to measure the impact of drawdowns is the MAR Ratio. It takes the average yearly profit (usually compounded in %, in our case, it’s not compounded as we’re always trading 1 contract) and divides it by the maximum drawdown. Which means, the higher the number, the better. If it’s above 1 that’s a good sign, and anything above 1.5 is really good. In our case, we got a MAR Ratio of 1.65, so the average yearly profit ($12.5k) is 1.65 times the maximum drawdown (-$7.5k). Which means to make those $12.5k on average a year, you’d have to endure a drawdown of about -$7.5k sometime in between. Sounds like a very good deal, doesn’t it? If it doesn’t then trading maybe isn’t the right business for you. No pain, no gain.

Now let’s have a more detailed look at the drawdowns:

This gives you a pretty good idea what you’ll have to make it through on a regular basis (up to -$3k drawdowns), sometimes (up to -$5k drawdowns) and the two worst cases that don’t happen often but you better are aware that they could (up to -$7.5k drawdowns).

So what happened at the end of 2016 was ugly, but not that unusual. Also, notice how quickly these drawdowns tend to recover (with the exception of 2013).

Again this is not what most traders want to think about. It’s so much more fun to think about the $12k profits a year per contract! But the day will come when you’ll be much better off to have thought this through. To be prepared when the shit hits the fan, and it will sooner or later. Then this kind of knowledge is what helps you to now throw in the towel at exactly the wrong time, to keep on trading, keep on pushing through and to make it to the next equity highs!

How to reduce drawdowns? The wrong path would be to try and somehow filter out these losing periods. That’s going to work in the backtest, but not in real trading. The best way to reduce drawdowns is to diversify. Trade more than one market. Trade more than one system. That’s what will make that MAR ratio go above 2 and higher.

Happy Trading!

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