Drawdowns: the number that measures the pain
What a drawdown is, why its length can hurt more than its depth, why a backtest's worst is rarely the worst, and what to decide before one arrives.
By Baris Demirci · · Rev00
The idea
A drawdown is a fall in the account from its highest point so far to a later low, before it gets back to that high. Every system has them. They are the part of systematic trading that people feel most, and the main reason they abandon a system that would have worked.
Two numbers describe a drawdown: how deep it went and how long it lasted.
- Maximum drawdown is the deepest of these falls over a period. It is the number most reports lead with.
- Time under water is how long the account stays below its last high. It is often the harder one to live through. A deep fall that recovers in months can be easier to bear than a shallow one that drags on for years.
Depth and recovery are linked by arithmetic: the deeper the fall, the larger the climb back, as position sizing shows. A fall to half needs the account to double.
The underwater chart
A drawdown chart turns the account line upside down. It shows, at every point in time, how far the account sits below its highest value so far. Zero means at a new high.
It is the most honest picture of a system, because it shows the part an account chart hides: how much of the time the account spends below where it has already been.
The backtest’s worst is not your worst
The maximum drawdown in a backtest is a single event on a single path through history. It is not a limit.
- History ran once. A different order of the same trades could have produced a deeper fall.
- The longer you trade, the more chances there are for something worse than anything in the test.
- The backtest is not you. It never skips a trade, overrides a rule or stops at the bottom.
Many systematic traders plan for falls well beyond the deepest one in their backtest, some for twice as deep, and size their positions so that even that would be survivable.
Different systems, different pain
The shape of a drawdown depends on the kind of system.
- Mean reversion tends to have rare, sudden falls, when a dip it bought turns into a collapse.
- Trend following and breakout systems tend to have long, grinding drawdowns made of many small losses while markets move sideways.
Knowing which shape to expect helps you tell a normal bad stretch from a broken system.
Decide what you will do before it happens
The worst time to decide what a drawdown means is in the middle of one. Systematic traders write the answer down in advance, while things are calm.
What it asks of you
- Expecting drawdowns. A system with no losing stretches in its test has usually been fitted to the past, not built to survive the future.
- Sizing for the worst case, not the average one, so that the deep fall you planned for is one you can live through.
- Not fixing the system at the bottom. Changing the rules in the middle of a drawdown usually means giving up the recovery that the rules would have caught.
The short version
A drawdown is the fall from a high to a later low, and the time it takes to get back. Its length often hurts more than its depth, and the backtest’s worst is a sample, not a limit. Know the shape your system’s drawdowns take, size for worse than you have seen, and decide in advance what a fall has to look like before you act on it.
Written for people building their own systematic portfolio management process. Nothing here is a recommendation to buy or sell anything. See the disclaimer.