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Maximum Drawdown

аThis is one of the most important aspects of a trading system. A very large drawdown is a negative factor, since it eliminates most traders from the game well before the system would have turned in its positive performance. Because most traders are not well capitalized, they cannot withstand a large drawdown. However, drawdown is a function of account size. Obviously, a $15,000 drawdown in a $100,000 account is not unusual; however, the same drawdown in a $35,000 account is serious. You may decide to risk large drawdown in order to achieve outstanding performance, but this is your decision.

Consider also the source of the drawdown by examining the largest losing trade. If the majority of the drawdown occurred on only one trade, you will be better off than if the drawdown was spread out over numerous successive losses.

Maximum Consecutive Losses. This performance variable is more psychological than anything else is. An otherwise excellent trading system may have lost money on many trades in succession.

Few traders can maintain their discipline through four or more successive losing trades. Even after the third loss, many traders are ready to either abandon their system or to find ways of changing it. However, at times it is necessary to weather the storm of 10 or more successive losses. If you know ahead of time what the worst-case scenario has been, you will be prepared. That's why it's important for your system test to give you this information.

Largest Single Losing Trade. This important piece of information indicates how much of the maximum drawdown is the result of a single losing trade. And this allows you to adjust the initial stop loss in retesting the system so as to see how large the average losing trade has been. If the average losing trade, for example, was $1055 and the largest single loser was $8466, you can readily see that a good portion of the average losing trade was a function of the largest loser. This shows that if you had a better way of managing the large loser (in hindsight, of course), your overall system performance would have been considerably better.

I strongly recommend close examination of the trade that resulted in the single largest loss if this loss is clearly much higher than the average losing trade. Another question to ask is "Why was the largest single losing trade so much larger than the stop loss selected?" A single largest losing trade that is several times larger than your selected stop loss points to a potential problem, perhaps with the system test. You must investigate further in such cases.