the market, when an account goes down in value, it's called
a drawdown. Suppose you open an account for $50,000 on August
15th. For a month and a half, the account goes straight up
and on September 30th, it closes at a high of $80,000 for
a gain of 60%. At this point regardless of your drawdown, you may still be in all of the
same trading positions. But as a professional, your account
is "marked to the market" at the end of the month
and statements go out to your clients indicating what their
respective accounts are worth.
say that your positions start to go down in value around the
6th of October. Eventually, you close them out around the
14th of October and your account is now worth about $60,000.
And let's say, for the sake of discussion, that your account
at the end of October is worth $60,000. Essentially, you've
had a peak-to-trough drawdown (peak = $80,000, trough = $60,000)
of $20,000 or 25%. This may have occurred despite the fact
that all of your trades were winners. It doesn't really matter
as far as clients are concerned. They still believe that you
just lost $20,000 (or 25%) of their money.
say that you now make some losing trades. Winners and losers,
in fact, come and go so that by August 30th of the following
year, the account is now worth $52,000. It has never gone
above $80,000, the previous peak, so you now have a peak-to-trough
drawdown of $28,000 -- or 35%. As far as the industry is concerned,
you have an annual rate of return of 4% (i.e., the account
is only up by $2,000) and you are now labeled as having 35%
peak-to-trough drawdown. And the ironic thing is that most
of the drawdown occurred at a time in which you didn't have
a losing trade -- you just managed to give back some of your
profits. Nevertheless, you are still considered to be a terrible
money manager. Money managers typically
have to wear the label of the worst peak-to-trough drawdown
that they produce for their clients for the rest of their
about it from the client's viewpoint. You watched $28,000
of your money disappear. To you it's a real loss. You could
have asked for your money on the first of October and been
performance, as a result, typically is best measured by one's
reward-to-risk ratio. The reward is usually the compounded
annual rate of return. In our example, it was 4% for the first
year. The risk is considered to be the peak-to-trough drawdown
which in our example was 35%. Thus, this traders reward-to-risk
ratio was 4/35 or 0.114 -- a terrible ratio.
you want to see ratios of 2 better in a money manager. For
example, if you had put $50,000 in the account and watched
it rise to $58,000 you would have an annual rate of return
of 16%. Let's say that when your account has reached $53,000,
it had drawn down to $52,000 and then gone straight up to
$58,000. That means that your peak to trough drawdown was
only 0.0189 ($1,000 drawdown divided by the peak equity of
$53,000). Thus the reward-to-risk ratio would have been a
very respectable 8.5. People would flock to give you money
with that kind of ratio.
take another viewpoint and assume that the $50,000 account
is your own. How would you feel about your performance in
the two scenarios? In the first scenario you made $2,000 and
gave back $28,000. In the second scenario, you made $7,000
and only gave back $1,000.
say that you are not interested in 16% gains. You want 40-50%
gains. In the first, scenario you had a 60% gain in a month
and a half. You think you can do that several times at year.
And you're willing to take the chance of giving all or most
of it back in order to do that. You wouldn't make a very good
money manager, but you might be able to grow your own account
at the fastest possible rate of return if you could "stomach"
the draw downs.
scenarios, plus numerous losing scenario, are possible using
the same trading system. You could aim for the highest reward
to risk ratio. You could aim for the highest return. Or you
could be very wild, and lose much of your money by risking
too much on any given trade.