is far different from watching at the sidelines. Unless a trader actually lives through an adverse trading experience, it is difficult to say how he may react. It is therefore wise to evaluate profits and losses separately to get a clearer view of how much "pain" we may need to endure. To help us along, risk/reward tools evaluate a systems profitability in relation to risk. In the simplest terms, drawdown represents various measures of loss (risk), while run-up represents measures of reward (profit).

Drawdown/Run-up

Tine in real tin

Drawdown

We will begin our discussion with drawdown. The measure of drawdown can be calculated in several ways: largest loss, maximum adverse excursion, average drawdown, largest consecutive losing series, or maximum equity loss. No matter what definition is chosen, drawdown must be calculated to gauge trading risk. If a trader is unwilling to accept the historical risks associated with a system, then the system should not be traded. Traders have a tendency to believe that major drawdowns will never occur while they are trading. A more realistic approach would be to believe that not only will it happen again, but also drawdowns may be even more severe in the future. Evaluating systems from this pessimistic point of view will help prepare traders for worst-case scenarios.

Depending on the definition of drawdown, a variety of risk numbers can be calculated (see Box 6). Each form of drawdown caters to a different personality type or trading style. There is no one correct calculation; they are all correct.

We will begin our discussion of drawdown with largest loss. This simple drawdown calculation represents the largest realized loss experienced by the system. Traders should be willing to accept this type of loss as a part of normal trading.

A better measure of drawdown is maximum adverse excursion (MAE).3 MAE can be calculated in a number of ways. In this discussion, we will cover two formats. The first represents the single largest unrealized loss experienced by a system. The second MAE calculation averages each individual trades largest unrealized loss. Essentially, this average adverse excursion figure (i.e., average drawdown) measures the typical risk experienced by the system.

BOX 6

DRAWDOWN

Largest loss: The largest losing trade for the test period.

Maximum adverse excursion: The largest unrealized loss based on the ultimate low for long positions or high for short positions during the trade.

Average drawdown: The addition of drawdowns for all individual trades divided by the total number of trades.

Largest consecutive losing series: The largest consecutive losing series for the test period.

Maximum equity drawdown: The largest equity dip during the test period, as measured from the highest running equity value to the lowest.

Figure 9.7 plots the individual MAE for each trade. The high of each bar represents the trades realized profit or loss at the close of the trade. The low of each bar represents the largest unrealized loss during the trade (i.e., the largest drawdown for the trade). Realized profit or loss is the difference between the exit and entry price, less commission costs. It is the real amount of money you will either gain or lose. Unrealized profit or loss is calculated from the price roller coaster ride that occurs during a trade. This movement does not affect you unless you are required to pay up on a margin call.

Using Figure 9.7 as a reference, the systems largest realized loss of $9,726 occurred on trade number 33. However, the trade with the largest MAE occurred on trade number 88 with an unrealized loss of $23,614. Curiously, this same trade actually reversed its unrealized loss to net a profit of $4,498 at the close of the trade. The average drawdown figure for this system is $4,544. This is basically the pain that a trader should expect to experience every time a trade is initiated. This is not to say that every trade will experience this unrealized loss, but preparing for it will put a trader in the correct frame of mind to literally feel comfortable trading this particular system. If a trader is reluctant to follow a system based on any of these drawdown tools, then he should look for another system.

The first set of drawdown tools center on individual trades. To complete the evaluation, we offer two additional drawdown figures that focus on a series of trades. A systems largest consecutive losing series and maximum equity drawdown are great measures of drawdown over time. They are easy to calculate and focus the traders attention on the bigger picture-the ability to continue to trade over time. A string of small losses may cause just as much pain as a single large loss. The largest consecutive losing series for the system reviewed in Figure 9.7 lost a total of $15,389 in four

P&L / Drawdown 1 qNSP 460000-Daily (08/19 85-08/01/97)

40000

20000 -

-i -20000 -

40000 -I-.-1--.-.-.-1-.-r-

1 11 21 31 41 51 61 71 81 91 Trade Number

consecutive trades: 64-67. The largest loss for the same system amounted to $9,726. Four little losses can produce greater pain than one large loss.

A series of multiple losses can have a greater influence on trading confidence then any single loss (see Table 9.8). In the example, the maximum equity drawdown of $31,900 is more than twice the largest consecutive losing series. The more forms of drawdown calculated, the better prepared the trader will be for trading into the future. As with all drawdown measures, if the figures exceed the traders threshold of pain, simply avoid the system.

Run-up

Traders have a tendency to overestimate their trading results by viewing their system from an optimistic point of view. The goal of this section is to temper this

Table 9.8 Drawdown analysis

Figure 9.7 Profit and loss drawdown.