V. 19:7 (28-34): Estimating Future Drawdowns by Tushar S. Chande

Estimating Future Drawdowns by Tushar S. Chande

You’re going to get hit by a big one sooner or later, but how big is it going to be?

There are three unknowns about the future performance of any trading system: the expected returns, the duration of drawdowns, and the depth of drawdowns. Of the three, the depth of future drawdowns is of the greatest interest because it threatens your survival as a trader.

Drawdowns are retracements in equity from previous equity highs — in short, losing periods. Of course, the exact depth of a particular future drawdown for any trading system or trading manager is unknown, since many random factors can affect the outcome. However, even reasonable estimates of the worst-case future drawdown would be enormously useful for planning purposes.

First, accurate estimates prepare you for the worst that could occur, without the implication that the system has stopped working. Such estimates give you an important psychological edge: You are more likely to stick with the system or trading program through future drawdowns if its magnitude has been estimated in advance. You can resist the temptation to abandon a trading system or manager too soon. In the long run, abandoning a succession of strategies near the lows of their drawdown periods will significantly reduce your returns.