Maximum drawdown in trading computation
Maximum drawdown is the maximum number of consecutive losses in trading. If you ignore drawdown in your existing trading system, it can contribute some massive losses in terms of financial trading capital. It is always important to have some data pertaining to the maximum possible drawdown of your trading system. One of the applications could be to compute the maximum risk you can trade.
Example number 1: You have a trading capital of around $2000 and you have a maximum drawdown of around 10 consecutive losses. And your trading account requires you to have a minimum of $500 trading capital in order to continue trading. Now if you risk around $175 per trade. Then what happens if you encounter your worst trading drawdown?
Total losses due to consecutive drawdown (commissions not included)= $175 x 10 =$1750, therefore the money left in your account will be:
Money left = $2000 – $1750 = $250
The money left will not allow you to continue trading.
Popular misconceptions about drawdown are that if you have such high drawdown, you have a poor trading system. This is not particularly true; it is because even with high drawdown as long as you have a clearly manageable losses and excellent money management, it can still translate to big profits.
By knowing your maximum drawdown, you are not afraid of the successive strings of losses. And it will help you manage your trade better. Lots of traders can be frustrated with successive strings of losses which in reality is normal.
The formula for maximum trading drawdown is slightly complicated however I have simplified the mathematics:
Maximum losing streak = Logarithm of odds losing streak to the base of loss probability
For convenience we will use base of 10 since this is common and accepted by normal calculators. Also we will fix the odds of losing streak to 1/10,000.
Let:
L be the trading losing percentage
Max = maximum losing streak
Converting to exponential function:
L^Max = 1/10000
Taking logarithms in both sides:
Log(L^Max) = Log(1/10000)
MaxLog(L) = -4
Solving for Max (the logarithm is now in base 10):
Max = -4 /Log(L)
Where: L is the trading losing percentage.
The above formula means that you have maximum losing streak that occurs at 1/10000 odds. Sometimes it can be rare, but these odds can happen (it is why they are used to compute the maximum). The above formula uses a base of 10 logarithms (also known as common logarithms in mathematics).
Case study:
A trading system has 50% winning percentage. Compute the maximum losing streak.
Trading losing percentage = 100% – %winning percentage
Trading losing percentage = 100% – 50% = 50%
Maximum losing streak = -4/ Log(0.5) = 13.2~14 trades.
Hence, at a 50% winning percentage, it might happen that you can experience 14 losses straight in a row (but very rare at 1/10000 odds). You need to prepare for this as it can happen.