This performance indicator has for investors about the same importance as Total Net Profit.
Total Net Profit stands for reward, therefore monitoring it is of course essential in order to be profitable. Nevertheless many traders still somehow neglect the key role that maximum drawdown plays, even though this is the indicator of risk they are taking!
Maximum drawdown basically represents the worst possible scenario and calculates the greatest loss we might potentially reach.
Maximum open trade drawdown is often interpreted as the subtract between two peaks (High and Low) in the equity curve.
Maximum drawdown is known to investment world in two forms: Maximum Open and Close trade drawdown, so let’s explore it further:
Assume that you are trading a long-term soybean futures contract and you are in a short position when the american departure of agriculture releases the WASDE report in which announces an unexpected decline in production. Suppose that surprisingly poor production causes an increase in the prices within a day, which have led to total loss on your account about $1500 a day.
This value of $1500 becomes your Open Trade drawdown.
Let’s expand our hypothetical simulation even further. The prices on the grains market has dropped by full point the morning after WASDE was released, it was only matter of few more days for the prices to get back up to the level of our entry price and are still slightly moving towards its initial level for next couple of weeks. We decided to finally close our position and generated a $200 loss.
These $200 are Closed trade drawdown for us.
So which one of these indicators have better informative value?
Open day drawdown is naturally more distinctive for small investors that trade with an account about 10000 – 20000$. It can even end up as so-called margin call, especially when it comes to extreme volatility. As every investor wants to avoid the demand to deposit additional money, it is extremely important to monitor maximum Intra-day drawdown rather than Trade Close to close drawdown.
MultiCharts and TradeStation provides these information within backtesting automatic trading strategies, they can be found in Performance Summary.
As we can see in the picture below, Max. open trade drawdown (Intra-day Peak to Valley) differs significantly from Max. drawdown Trade Close to Trade Close. Trader whose aim is to be profitable in long-term has to keep an eye on expected returns to the amount of risk undertaken NetProfit/Max Intra-day and not only the reward or loss itself (Trade close to close drawdown).
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