You Are in a Drawdown. When Should You Start Worrying?

Abstract

Trading strategies that were profitable in the past often degrade with time. Since unlucky streaks can also hit "healthy" strategies, how can one detect that something truly worrying is happening? It is intuitive that a drawdown that lasts too long or one that is too deep should lead to a downward revision of the assumed Sharpe ratio of the strategy. In this paper, we give a quantitative answer to this question based on the exact probability distributions for the length and depth of the last drawdown for upward-drifting Brownian motions. We also point out that both managers and investors tend to underestimate the length and depth of drawdowns, consistent with the Sharpe ratio of the underlying strategy.

A Rational Risk Policy? Why Path Dependence Matters

“…The results obtained through this simulation exercise can be used to establish a maximum drawdown corridor along the lines of [36]. The upper boundary on the maximum drawdown can, for example, be defined as a level of maximum drawdown that can only be exceeded with a 5% chance.…”

“…More specifically, we demonstrate the importance of drawdown risk in the case of repeated favorable opportunities. Rej et al [36] point out that managers and investors tend to underestimate the length and depth of perfectly normal and acceptable drawdowns.…”

Extreme Events for Fractional Brownian Motion with Drift: Theory and Numerical Validation

“…Examples are records [1], e.g. in climate change [2], equivalent to depinning [3], in quantitative trading [4], or for earthquakes [5]. While much is known for Markov processes, and especially for Brownian motion [6][7][8][9][10][11][12], much less is known for correlated, i.e.…”