The Point is Drawdown Control
What’s the point of all this Monte Carlo simulation? That, is a very good question.
For us, fundamentally, it’s about how we can control our maximum drawdown. That’s our prime motivation. We absolutely suck at handling drawdowns, so we wanted to create a money management / risk management system that would protect ourselves from ourselves and the vagaries of the market.
Actually it’s kind of a two pronged strategy – we want to minimise our maximum drawdown potential and in so doing, reduce the amount or return we subsequently require to get back to breakeven.
Drawdown is trading career killer.
If you let your drawdown get seriously out of whack, the returns required to get back to breakeven make it practically impossible to do so in any reasonable timeframe.
The table below illustrates this point.
| Equity | Loss in % | % Gain Required |
|---|---|---|
| $100,000 | 0% | 0 |
| $95,000 | -5% | 5% |
| $90,000 | -10% | 11% |
| $85,000 | -15% | 18% |
| $80,000 | -20% | 25% |
| $75,000 | -25% | 33% |
| $70,000 | -30% | 43% |
| $65,000 | -35% | 54% |
| $60,000 | -40% | 67% |
| $55,000 | -45% | 82% |
| $50,000 | -50% | 100% |
| $45,000 | -55% | 122% |
| $40,000 | -60% | 150% |
| $35,000 | -65% | 186% |
| $30,000 | -70% | 233% |
| $25,000 | -75% | 300% |
| $20,000 | -80% | 400% |
| $15,000 | -85% | 567% |
| $10,000 | -90% | 900% |
| $5,000 | -95% | 1900% |
Take special note of how much harder it becomes to get back to breakeven the worse you let your drawdown get.
At 10% drawdown it’s not too bad - you only need 11% to get back to breakeven. So the get back to breakeven % gain required is about the same as the damage to your account.
But at 20% drawdown, life’s getting a little harder. You need to earn 25% to get back to breakeven.
With a 40% drawdown you need to earn 67% to get back to breakeven.
And if you let things go to a 50% drawdown, then you need a 100% return to get back to square.
And it just gets harder and more difficult from there. A 60% drawdown requires a 150% return, and 75% drawdown requires a 300% return to get back to breakeven.
So what do you do if you find yourself on the wrong side of the markets and your drawdown is getting away from you? Probably stop trading. Then review, assess and adapt / change to survive.
However we prefer to plan ahead. We use our Monte Carlo simulations to develop scenarios to head our worst drawdown off before it even occurs. We want to limit our maximum drawdown to what we consider we can handle psychologically, and also what we may be able to remedy with a reasonable performance to get back to square.
And do not underestimate the impact of drawdown on you psychologically. That grey matter between your ears causes weird and irrational behaviour if you let the demons loose with your trading equity and a bad drawdown. Do not chase losses with bigger bets!
To get some insight into what other professional trader’s performance looks like, check out what the managed futures industry participants achieve on iasg.com, at this link. A study of your competition may shatter some of your wild illusions about how good or bad your future may be. Compare yourself to your peers in the rest of the world. It may be humbling.
In particular at IASG, check out the CAROR (Compound annual rate of return) AND the WDD Worst Draw) columns. Note that you can sort each column by clicking on the headings. Have a look around.
Then if you click and sort the ”Inception” column you can see some of the most famous and oldest survivors such as:
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Dunn Capital Management with 12.55% CAROR, and a WDD of -57.88 since 1984. Bill Dunn was an early pioneer in applying quantitative techniques to financial markets. Here’s more on Dunn Capital at this link and this link.
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Eckhardt Trading Company with 10.03% CAROR and a WDD of -27.11% since 1991. William Eckhardt is also famous for his Turtle Traders experiment, which started with a bet with his then trading partner Richard Dennis. Here’s more on Eckhardt Trading at this link and this link.
Then sit down and contemplate your own performance. Do you think you can ride out a 40% drawdown and then back it up with a 67% return to square your ledger? If you can do this you will be in esteemed company.
So how much pain / drawdown can you really bear? I think that’s a personal decision and depends on each trader, and unique to every individual.
However for us mere mortals we don’t want to cop anything near a 40% drawdown.
We therefore set out to create a set of rules to prevent this. Monte Carlo simulation is the best tool we’ve found to let us do exactly that. We can test our “what ifs”, and calculate our chances (probability) of certain events coming to fruition in our probabilistic crystal ball of the future.
In essence we control our risk per trade, which in turn has a direct and fundamental impact on the magnitude and probability of our future maximum drawdown.
It’s a work in progress, and we’re still running scenarios in search of an “optimum” strategy for us. We have a “rough” strategy we already trade with, but we figure there’s a better one out there somewhere.
So, how much drawdown and it’s commensurate emotional pain can you bear? And what are your chances of being able to get back to even and then generate a new trading equity high?
We suggest you use Monte Carlo simulation to find out!
More later.
Trade small to survive.