Drawdown is a crucial metric in backtesting that helps traders understand the potential risk and volatility of a trading strategy. It measures the decline in a trading account from a peak to a trough, providing insight into the losses experienced before a recovery to new highs. By interpreting drawdown results, traders can assess a strategy’s risk tolerance, stability, and suitability for their trading goals. Here’s a guide on how to interpret drawdown results in back testing and what these results indicate for real-world trading. How to interpret drawdown results in back testing? Lets find out.

What is Drawdown?

Drawdown is the reduction in equity or account balance from the highest point (peak) to the lowest point (trough) before the account reaches a new high. It’s typically represented as a percentage of the starting or peak balance. In backtesting, there are three primary types of drawdown metrics:

1. Maximum Drawdown (MDD): The largest peak-to-trough decline during a specified period in backtesting. It’s the deepest loss an account experienced before returning to a new high, and it provides insight into the worst-case scenario.
2. Average Drawdown: The average of all drawdowns recorded during the backtesting period, showing the general volatility and risk profile of the strategy.
3. Recovery Time: The duration it takes for the account balance to recover from a drawdown back to its previous peak. This indicates how quickly a strategy can rebound from losses.

How to Interpret Drawdown Results

1. Maximum Drawdown (MDD) and Risk Tolerance

Maximum drawdown is the most crucial metric, as it represents the worst decline the strategy experienced. A high maximum drawdown can indicate that a strategy carries substantial risk and might exceed a trader’s tolerance level.

• Low Maximum Drawdown: Indicates a less risky strategy. Strategies with low MDD are generally safer, offering stability with moderate losses. However, they may also yield lower returns.
• High Maximum Drawdown: Signals a riskier strategy with larger declines in equity, often associated with higher returns. This level of drawdown might not be suitable for risk-averse traders.

For example:

• If a strategy has a maximum drawdown of 20%, it means that at some point, the strategy incurred a 20% loss from its peak. A trader needs to decide if they are comfortable with the potential for such a significant decline.

2. Average Drawdown and Strategy Volatility

The average drawdown gives a sense of the typical volatility or regularity of losses in a strategy. Consistently high average drawdown suggests that a strategy is prone to frequent, significant losses and may require higher risk tolerance.

• Low Average Drawdown: Indicates a stable, conservative strategy with less frequent or severe declines.
• High Average Drawdown: Suggests a volatile strategy where declines are more common, which could affect a trader’s ability to handle consecutive losses.

For example:

• If a strategy’s average drawdown is 5%, it implies that, on average, the account experiences a 5% loss during a typical drawdown event. This level of drawdown could be manageable for most traders, but it’s essential to consider it in conjunction with MDD and recovery times.

3. Recovery Time and Strategy Resilience

The time it takes for a strategy to recover from drawdown periods is crucial, as prolonged drawdowns can strain trader confidence and capital availability. A strategy that recovers quickly from losses is generally more resilient and can give traders greater peace of mind.

• Short Recovery Time: Indicates a strategy that bounces back quickly from losses, which is ideal for maintaining capital and confidence.
• Long Recovery Time: Implies that the strategy struggles to regain ground after losses. A long recovery period can indicate an increased risk of prolonged underperformance.

For example:

• A strategy with a maximum drawdown of 10% but a recovery time of only one month may be more attractive than one with a 10% drawdown but a recovery time of six months. Faster recovery times help traders resume growth more quickly after losses.

Comparing Drawdown to Performance Metrics

Drawdown should always be considered relative to the overall performance and returns of the strategy. Here are a few comparisons to help interpret drawdown results more meaningfully:

Drawdown vs. Return

A strategy’s risk-return ratio is a key factor when interpreting drawdown. High returns may justify a higher drawdown, while low returns may not warrant any significant risk.

• High Return with High Drawdown: May be acceptable for aggressive traders willing to take on more risk.
• Low Return with High Drawdown: Indicates an unfavourable risk-return balance, suggesting the strategy might not be worth pursuing.
• High Return with Low Drawdown: This is the ideal scenario, representing strong performance with minimal risk exposure.

Drawdown vs. Sharpe Ratio

How to interpret drawdown results in back testing? The Sharpe Ratio measures risk-adjusted returns and can help put drawdown into perspective. A high Sharpe Ratio with low drawdown is generally preferred, as it indicates strong, consistent returns with less risk.

• High Sharpe Ratio with Low Drawdown: Suggests a reliable, low-risk strategy with steady returns.
• Low Sharpe Ratio with High Drawdown: Implies a risky strategy with inconsistent returns, which may not be sustainable.

Drawdown vs. Win Rate

The win rate is the percentage of profitable trades in a strategy. High drawdown with a low win rate might suggest an overly risky strategy, while high drawdown with a high win rate could indicate that large losses from a few trades are offset by numerous small wins.

• High Drawdown, High Win Rate: May indicate that occasional large losses counteract frequent smaller wins.
• Low Drawdown, Low Win Rate: Shows that even with fewer winning trades, losses are managed well, indicating a stable strategy.

Interpreting Different Levels of Drawdown

Drawdown Level	Interpretation
0-5%	Very low risk, suitable for conservative traders
5-10%	Moderate risk, manageable for most traders
10-20%	Higher risk, acceptable for traders seeking growth
20-30%	High risk, suitable only for aggressive or experienced traders
30%+	Very high risk, typically not recommended for most traders

FAQs

What is drawdown in trading?

Drawdown measures the decline in account equity from a peak to a trough, indicating the level of losses experienced before recovery.

Why is drawdown important in backtesting?

Drawdown helps traders evaluate the potential risk and volatility of a strategy, giving insight into the worst-case loss scenarios and strategy resilience.

How is maximum drawdown different from average drawdown?

Maximum drawdown is the largest decline from peak to trough, while average drawdown represents the typical size of all drawdowns over time.

What is a good drawdown level?

Generally, a drawdown below 10% is considered low risk, while anything above 20% is high risk. A “good” level depends on a trader’s risk tolerance.

What is drawdown recovery time?

Recovery time is the period it takes for a strategy to recover from a drawdown and reach a new peak. Short recovery times indicate a resilient strategy.

How does drawdown affect strategy performance?

High drawdown indicates higher risk, which may deter traders or require adjustments to position sizing and risk management.

What is a high drawdown?

A drawdown of 20% or more is generally considered high, as it represents a significant loss from peak to trough.

How does drawdown relate to risk tolerance?

Drawdown directly impacts risk tolerance, as higher drawdowns require a trader to withstand larger losses and potentially prolonged recovery times.

Can drawdown be reduced?

Yes, strategies like adjusting position sizing, diversifying trades, or adding stop-losses can reduce drawdown, though they may also reduce returns.

Is low drawdown always better?

While low drawdown reduces risk, it may also limit profit potential. The ideal drawdown level balances risk with acceptable returns.

Conclusion

How to interpret drawdown results in back testing? Understanding and interpreting drawdown results is essential for evaluating the risk profile of a trading strategy. By analysing maximum and average drawdown along with recovery time, traders can determine if a strategy aligns with their risk tolerance and objectives. For in-depth insights and training on risk management and trading strategies, explore our Trading Courses at Traders MBA.