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I first came across this idea several months ago, but at first I did not
fully understand. The fog is now lifting, and I want to toss this out,
first, to get other people's thoughts and reactions, and second, to collect
my own thoughts.
Simply stated, drawdown is the largest equity dip caused by a sequence of
losing trades, and many use it to assess whether a system is tradeable.
Assuming there is no mathematical dependency between wins and losses (ie. a
win does not beget a win, or a win does not beget a loss) in a system, the
fact that your system test just happened to find, say, five consecutive
losses is irrelevant. Consider a series of coin tosses. Even though there is
a 50% probability of heads, a sequence of five consecutive tails is fairly
common, but shouldn't influence a person to not bet on heads. In fact, a
sequence of 10 consecutive tails is quite possible, yet the probability of
heads on the next toss is still 50%. An analysis of this 10-sequence
drawdown might mislead an investor into believing the coin-toss trading
system is too risky. In contrast, let's say that the series of coin tosses
yielded no consecutive losses, thereby giving the investor the false
impression of a small risk. In either case, the calculated drawdown is
meaningless.
If there is no dependency between wins and losses, can we expect past
drawdowns to repeat? Can we expect future drawdowns to be bound by past
extremes? No; there is no limit to the possible number of consecutive losing
trades. Drawdown is not meaningful, other than to give some false peace of
mind.
Since there is no limit to the number of possible consecutive losses and it
is uncontrollable, the better yardstick is the size of the largest losing
trade. To an extent, this can be controlled. And with proper money
management techniques, you can structure your trade sizes so as to survive
the inevitable string of losses.
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