How the statistician drowned (or return over maximum drawdown)

 

There’s an old joke about a statistician who drowned crossing a river after seeing that the average depth was 3ft.

Admittedly, it’s not exactly funny … but it does tell us how important information can be hidden in averages, and that we should be more prepared for the unusual extremes.

Yet, again and again, we’re surprised by big losses and extended drawdowns, despite years of watching results curves littered with peaks and troughs.

Things we don’t like to look at

Big losses and nasty drawdowns are neatly filed away under ‘things we really don’t like to look at or think about’. And, by ‘filed away’, I mean that we mentally put them into a locked filing cabinet and don’t examine them in too much depth.

In fact, we might pat ourselves on the back that we haven’t allowed ourselves to ‘dwell’ on these negatives – we’ve picked ourselves up and are bravely carrying on.

But if we don’t examine these painful blips in our trading, we could be, at worst, repeating the same mistakes again or, at best, not preparing ourselves for the next time this happens.

Looking hard at equity dips

If you want to trade successfully over the long term, it’s important to dig into our drawdowns and big losses. It’s never the most comfortable feeling, but when you come out the other side with a plan – you’ll find it lifts a lot of stress from your trading.

Here’s my plan of attack when faced with a drawdown …

A lot of traders look a little blank when I ask them about historical expectations for drawdowns …

We know what kind of profits we expect …

We may also know a little about our trading edge …

But what’s our worst drawdown? And how do we measure drawdowns?

Do you know your RoMaD?

RoMaD is the not-so-snappy name for Return Over Maximum Drawdown.

The clue for how you calculate it … is in the name.

We literally put our profit over our maximum drawdown ….

REWARD
_________________

MAXIMUM DRAWDOWN

So, taking an example from HAV Trading in 2021, this made a profit of £22,330, with its worst drawdown in that same period of £5,050

This gives us a RoMaD of 22330/5050 = 4.4

Generally, we’re looking for a RoMaD over 2, but it’s really a very personal decision – what do you feel comfortable risking, relative to the potential rewards?

When will your worst drawdown be?

An uncomfortable truth for traders is that our worst drawdown will always be ahead of us. It’s a fact of trading that profits will go down as well as up, and the longer you trade for, the more of these losing periods you’ll have to navigate.

However, that shouldn’t mean that our RoMaD has to suffer.

Looking again at the example above for HAV Trading, over the past 12 years, I’ve had more significant drawdowns, however, I’ve also made a great deal more money, which means that my RoMaD over the 12 year period is over 6.3 – it’s a figure I’m very proud of, especially as it’s achieved in just 10 minute work each week!

Keeping track of your RoMaD over the long term is a good way to keep losses in perspective, but also lets you know when things are going off-course and require action.

And by being proactive in preparing for a dealing with losses, you’ll find that you feel safer moving forward and trading becomes a more stress-free activity.

 

To enjoy more content and get it faster Follow @TradersBulletin