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# Drawdown simulation and trading systems selection

Discussion in 'Risk Management' started by palm, Nov 24, 2009.

1. ### palm

Method
Suppose i have a trading system A which has historical 100 trades data. I ran simulation 10,000 trials and look at the worst drawdown that this system A could have produced by chance alone. Let's say that System A has max simulated Drawdown (DD) at -40%. Now if I set my maximum drawdown of my portfolio at -20%, i will be trading system A by only half of my portfolio to ensure that when the worst comes, i won't be down more than -20%. By the same token, if system B has max simulated DD of -10%, i will be trading 200% of my portfolio on system B.

Questions:
Currently I set every system that i have equally at -20% max portfolio DD. Here's what i mean

System/ A B
Max Simulated DD / -30% -63%
Portfolio Max allowable DD / -20% -20%
Market exposure adjustment % / 70% 33%
Annual Expected Returns (100% market exposure) 36% 24%

For example, if i have \$100,000 portfolio, i will trade system A at 70,000 market exposue in a given trade. And i will trade only \$33,000 worth of market exposure on system B. This also mean that my expected returns will be geared down accordingly. So system A will now have expected returns to my portfolio of (36%*70%) = 25.2%. And system B will give me 7.9% returns to my portfolio.

Now here's my question, by setting each system max DD to -20% of the total portfolio, i am willingly allow each system an equal chance of damaging my portfolio. You would ask, why should i allow system B which can generate only 7.9% returns to my total portfolio to have the same damaging effect on my portfolio. In other words, should i set B at -15% instead of -20%? How about setting A at -25%? What should be my method in setting this Portfolio Maximum Allowable DD when i take into consideration the expected returns of each system?

Any comment is welcome.

Thank you

2. ### TraderZones

Not going to dissect your sim logic, but in real life, longterm trading, it is a lot more complicated.

3. ### mkz160

1. It looks like -20% is the boundary for you between fear and panic emotions. Stick to it (it is your risk profile).

2. You presented no evidence that all your systems have the same probability to hit the -20% DD. Some will do it more often.
And probably they all are correlated. So, on some black swan most of them will touch -20%. Maybe not.
Will see after few trades and kick out the worst performer out of your portfolio.

Cheers

4. ### adadadog

When I did my backtesting, I set a mdd, it primarily depends on the portfolio size. If a system's mdd is far less than my threshhold mdd, I drop mdd as a factor in judging the system, but use car, compounded annualized return; if the mdd is close to my threshhold mdd, I use car/mdd.

5. ### bashatrader

Future drawdown can be many times past drawdown. Silly to base anything on past drawdown.

6. ### Murray RuggieroVendor

If a system is well designed and tested, drawdown in the future will most likely increase over time but can be accounted for. In general if drawdown increases by 2X, then the system has failed and should not be traded any longer. This is just a rule of thumb and not absolute.

Also often times before a system exceeds it's previous drawdowns, you can see changes in the footprint of the trades. This can clue you into something is wrong.

7. ### thetrendfollowe

I agree.

I anticipate double maxDD in trading as per testing and half the CAR, and if that is not enough for me, than back to the drawing board.

eg. If I get a system that backtests at 40%pa with 15%maxDD then I anticipate 20%pa and 30%mDD.

If you can sustain 20%pa returns for long periods of time it puts you up there with the great ones.

Start young, think big, and most importantly, stick at it

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