Drawdown and Recovery

The equity curve

Plot account equity after every trade. The curve rises in steps and falls in steps, and the distance from each new low to the previous peak is the drawdown at that point. Two numbers summarise it: the maximum drawdown as a percentage, and the longest time between one peak and the next, which is the recovery period. A strategy with a 12 percent maximum drawdown and a four-month recovery is easy to live with; one with 35 percent and a year of recovery will be abandoned by almost everyone before it recovers, whatever its expectancy.

Expected drawdown

From win rate, average win and loss, and risk per trade, you can estimate the drawdown a strategy will produce in a normal run of bad luck. A 40 percent win rate strategy risking 1 percent per trade should expect losing streaks of nine or ten, and therefore drawdowns of around 10 percent, as a matter of routine. Knowing the expected figure stops you panicking at a normal one.

When it means stop

• The current drawdown exceeds the historical maximum by a clear margin: investigate before trading on.
• The drawdown is within the record but you have broken rules: fix the execution.
• The drawdown is within the record and the rules were followed: continue, at the same size or slightly reduced.
• The drawdown reaches the plan's stop level: stop live trading and go back to testing, without exception.

Recovery

Recovery from a drawdown takes a larger percentage gain than the loss, and it takes time proportional to expectancy and trade frequency. The drawdown recovery calculator shows the gain needed and, for a given expectancy, roughly how many trades. Reducing size during a drawdown slows the fall and slows the recovery equally; the choice is a matter of temperament, and the plan should make it in advance.

Key takeaways

• Track maximum drawdown and recovery time from the equity curve.
• Estimate the expected drawdown so a normal one does not look like a crisis.
• Stop when the drawdown exceeds the record or reaches the plan's limit.
• Recovery is asymmetric; the calculator shows the gain needed.