To evaluate the goodness of an investment strategy is necessary to analyze the chart showing the trend of the capital. Then you can evaluate some indices that extrapolate the most important information on the progress of investments. One of the most important indices to consider is the drawdown that is normally reported in percentage or in absolute terms.
The technical definition of drawdown is the following:
The drawdown represents the 'intensity of reduction of capital in percentage terms or absolute terms and may be referred to a single order or to the entire strategy. It represents the amplitude of a decrease in capital and it are reported to the capital value that take place before the loss.
If we relate the drawdown to a single operation, saying that the operation had a drawdown of 20% means that capital, as a result of that operation, has suffered a negative swing of 20% although in the end perhaps it is was closed with a gain! Infact, when we place an order (for simplicity without SL and TP) our capital starts to float up to the moment when we decide to close the order. It 'just in time that we're going to see the floating drawdown (the negative excursion produced in our capital). The loss (or gain) arises when we close the order and consolidate the result inside of our strategy.
Consider an investment strategy and assume that a trader invests capital (initial) of 10.000$. After a series of successful operations have come to 20.000$, but then, due to certain transactions closed at a loss, the share increased from 20.000$ to 15.000$, then go up again to 18.000$. Even if the trader has never reached the initial capital and therefore has always been in a gain situation, the drawdown of the sequence of operations is 5.000$ because it is related to the peak value (20.000$) reached before the loss.
The drawdown is therefore a very important property of any strategy or expert advisor. It represents in the graph of the capital, the difference between a local maximum and the next local minimum and is a measure of risk associated with a strategy. The next DrawDown will start when you get a new high of more than the previous.
The drawdown can be expressed as a percentage of the maximum capital amount to which it refers, in which case we speak of Relative DrawDown.
When we consider a trading strategy, since we have over time a succession of different drawdown, we can evaluate the Maximum DrawDown and the Average DrawDown.
Maximum DrawDown is the largest DrawDown obtained and provides information on the worst-case we can expect and an estimate of the maximum loss you may suffer after reaching a certain profit.
Average DrawDown represents the average value of the drawdown occurred during the work of a strategy or Expert Advisors.For example, if the strategy had 3 drawdowns, a 4%, 'a 5% and 9% drawdown, the average is 6%. Unlike the Maximum DrawDown which refers to the worst-case, this value gives us a measure of loss that we can be expect normally.
These two parameters should be evaluated together to have a measure of the potential decrease in capital in which we incur with the Strategy.
An analysis of the profitability of a strategy should always take into account the drawdown and should have as a first step the analysis of the chart of the equity and subsequently an analysis of the numerical values of these parameters.
Another important parameter is the DrawDown Absolute which can be referred either to the entire strategy (with a maximum value and then a medium), or to the individual transaction. The feature of Absolute DrawDown is that the fluctuation,instead of being related to the capital reached before the negative fluctuation, is related to the initial capital and is a measure of the difference between the initial deposit and the lowest value (less the initial deposit) reached from the capital throughout the period.
To get an idea of the information provided by these two parameters we consider a good trading strategy. The curve of Equity, which represents the trend of capital in relation to the profits or losses as they occur, will have a growing global trend and some small negative peaks. In this case we have a low value of maximun drawdown and even lower value of average drawdowm.
We consider now a bad trading strategy with equity in a zigzag pattern around the horizontal line representing the initial capital. This strategy will have a big value of maximum drawdown and a big value of average drawdown and what we perceive is the uncertainty of the results related to this strategy.