We've all heard the term, “drawdown” from time to time when referring to the performance of stock trading systems. A trading system's, “maximum drawdown” is an extremely important performance metric. Why is that you ask? Simple, because the maximum drawdown is the greatest peak to valley draw in equity that a trading system has experienced.
Your trading system's equity is a snapshot of your trading account health. Your equity is the sum total of all winners and losers to date. All account equity fluctuates as the stock market is dynamic and your particular trading system is more in sync with the markets dynamics on some days than on others.
There are times when your trading system may have a series of losing trades, either consecutive losing trades or more losing trades than winning trades over particular period of time. It is during these periods that your account equity will go into drawdown. Please understand that drawdowns are a natural part of trading and everyone's account has them. A good trading system will pull out of the equity valley of the drawdown and go not only to the previous equity highs, but to new equity highs in the future.
Now we've had little overview of account equity and drawdowns let's chat about why the performance metric “maximum drawdown” is so important. The maximum drawdown is important because it helps you set your expectation level and anticipate that if such a drawdown has happened in the past then it is possible that this same drawdown can happen again in the future. This is crucially important when evaluating hypothetical trading systems prior to their use. The trading system's maximum drawdown immediately tells you important things about the trading system. For instance, if your considering trading a system with $50,000 drawdown and you have a $10,000 trading account, then you know immediately that is not currently the system for you.
Many beginning traders make the mistake of trying to play it too close to the vest with regard to the working capital in their account. Similar to haggler's at a fleamarket they always seem to be trying to get away with investing as little as possible. While this works great at the fleamarket, in real-time, real-life trading not having a financial buffer has been the downfall of many would-be trader.
If you're considering using a particular trading system and you do not know what the maximum drawdown is then is quite logical that you should not pursue trading system under any circumstances. Without knowing the maximum drawdown you simply do not understand the risk of trading that particular system.
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