Chapter progress:

Drawdown means the amount of loss taken in a position before recovery to the last highest profit. For example, you have made $1,000 trading Forex and then you take a series of losses for a total of $300.00 or 30%. At this point your account has reached its lowest low and after that, you start recovering what was lost. It takes you six months to recover the full $1,000.00. You would say that your peak-to-valley drawdown was 30% and your recovery period was six months. Notice that you cannot measure a loss until it has been fully recovered, so technically you cannot say the drawdown is over until the amount recovered is $1,001.00.

Drawdown can apply to your overall portfolio or to a single currency. Relative drawdown, where the loss is expressed in percentage terms from the peak balance, is how professional managers are judged, as well as time to recovery from drawdown. An old rule of thumb used to be that a drawdown should not exceed 30% nor take longer than six months to recover.

For practical purposes, the non-professional trader should look at drawdowns on a currency-by-currency basis. The retail trader should look at relative drawdown (percentage basis) and may also choose to look at it as absolute drawdown, meaning the number of dollars (or home currency) lost. This is logical since we set stops and profit targets in terms of dollars. No matter how much capital stake you have, the absolute loss in dollar terms is a number you need to know in order to figure out a way to dig yourself out of the hole. Do you widen your profit target? Trade more contracts?

Everybody in the Forex business knows at least one trader who made $500,000 in his first year and then lost 95% of it, so now he is trading with $25,000 — ten years later. These are the traders who examine and re-examine the techniques they were using that generated the series of losses, imagining that if they could tweak their indicators just a little, the losses could have been avoided — and will be avoided next time. While self-examination is often a useful exercise, sometimes losses must be attributed to bad management rather than substandard indicators, like not using the correct stop-loss levels, or to unavoidable external shocks, the Black Swans of geopolitics.

Professionals are not allowed the luxury of neurosis. Investors in hedge funds and managed futures funds employ metrics to weed out managers who fail to control drawdowns. Each of the ratios used to measure riskiness by focusing on drawdowns is a variation of the core concept — divide the return over some period by the average drawdown. This yields a risk-reward measure. Investors seek the highest return together with the lowest volatility of returns, and drawdown is a measure of volatility — not the volatility of the underlying security but rather the volatility of the returns.

The MAR ratio, devised by the editors of the Managed Account Reports newsletter, measures its ratio from the inception of the trading firm divided by the maximum drawdown from inception.

The Calmar ratio, named for the inventor, California Managed Accounts, uses the annualized rate of return divided by the maximum drawdown for the past 36 months and performs the calculation on a monthly basis (instead of annual).

Calmar Ratio = Annualized Rate of Return for Past 36 Months / Maximum Drawdown over Past 36 Months

The Sterling Ratio is the annualized return for the last 3 years divided by the average of the maximum drawdown in each of the preceding 3 years, less an arbitrary 10%. This is an extra feature that embodies the assumption that all maximum drawdowns will be exceeded.

The Sterling ratio = Compounded Annual Return / (Average Maximum Drawdown – 10%)

The Sterling ratio is usually applied over three years, like the Calmar ratio. Let’s say the manager has returned 35% compounded over three years but has an average maximum drawdown of 35% over the three years. The Sterling ratio would be 35/25 = 13.73%. This number represents the risk-adjusted return.

Now consider another manager who has only a 20% return but an average drawdown over the same three years of 10%. His Sterling ratio is 20%, or a far higher risk-adjusted rate of return. Analysts assume that when using the risk-adjusted rate of return to allocate money to different managers, the future performance will be similar to past performance, and 20% net is better than 13.73%.

Other ratios are used to evaluate managers. The most famous is the Sharpe ratio, named for the Nobel Prize winning mathematician William F. Sharpe. The Sharpe ratio does two things — it subtracts the “risk-free” rate of return from government bonds that are the alternative to active trading, and it divides the return by the volatility of the investment. Therefore, an investment that has a 10% return would first have 5% subtracted (the risk-free rate of return) and be divided by, say, a volatility of 10%. The Sharpe ratio is 0.50. Now take an investment that returns less than the first one, only 7%, but has a volatility of only 2%. Now the Sharpe ratio is (7-5)/2 = 1.0. The higher the Sharpe ratio, the better the investment — if you are seeking to minimize risk.

The Sortino ratio is like the Sharpe ratio except that it includes the target rate of return and does not care about two-way volatility, only downside volatility that results in losses — i.e., drawdowns:

Sortino ratio = (Rate of Return – Target Rate of Return) / Downside Deviation

How to Think About Drawdowns

Very few active Forex traders actually use any of these ratios on their own P&L performance statistics, although they probably should, if only to see whether they might be better off just giving their capital to a manager instead of trying to do it themselves. But the prime motivation of many traders is precisely to do it themselves, and in any case, the minimum capital requirement to join a reputable managed fund is usually $100,000 or more, and most traders do not have that kind of spare change. They are trying to build capital, not allocate it.

Applying a simple Calmar or Sterling ratio to your own performance statistics is a good idea to measure how well you are doing, especially if you use a rolling monthly basis. The Sortino ratio, if you can master the math of determining the “downward deviation,” basically tells you whether you should stay in the trading business. If you could earn 7% by placing your funds in the Australian dollar denominated bonds, with no downside risk if you hold to maturity, but your actual Forex trading return is less than 7% while you are taking drawdown risk, logically you should get out of trading and into invest-and-hold. In other words, your rate of return after accounting for the risk of drawdown should be better than what you can get risk-free.

Hardly anybody wants to face this uncomfortable deduction.

Another good reason to have a passing acquaintance with drawdown ratios is to be qualified to evaluate a trading system that you might become interested in buying.

Quiz:

1. You should judge drawdowns on which basis?

2. Risk-reward ratios measure

3. In risk-reward ratios, the better number is

Done