I’ve talked a lot about Max drawdowns and drawdown durations but there is another metric we should all take a look at – the average drawdown. I’ve alluded to his metric in the blog article Not All Drawdowns Are Created Equal and now I have a way to measure the top 5 drawdowns.
The actual metric is certainly not complicated, the average of the top 5 drawdowns, however, the reason you should use it can get a little more complicated. In order to understand the Average Drawdown we need to revisit the Underwater Equity Chart. “The Underwater Equity curve, popularized by Jack Schwager, presents a trader with a unique way of evaluating equity performance. Using this graph, the trader can view the relationship between time and magnitude of drawdown as they relate to new equity highs. This graph enables the trader to look at the performance from a pessimistic viewpoint pinpointing how much drawdown occurred and how long it took to rebound to hit a new equity high.”
From the Underwater Equity Chart below, you’ll see it had a spike down in August 2011 but all the other drawdowns were much less. From this chart you can see the Maximum Drawdown (MDD) was about -21%. A MDD of -21% wouldn’t have been enough to make me walk away but let’s look at this a little closer. As you can see from the chart, this drawdown took place in August 2011 (I looked at the monthly profit charts to confirm), the month the US debt was downgraded by Standard and Poors. But up until August 2011 the MDD had only been a little over 16% and within my parameters of an acceptable drawdown. Since August 2011, the MDD was around -10%, certainly nowhere near the -21%.
So averaging the top 5 largest drawdowns you get-13.55%.
I have included the Average Drawdown in the Performance Matrix