Risky Proposition (Part 1)

Continuing on with a previous discussion about normalizing risk:

     > Position sizing should be held constant throughout the   [1]
     > [duration of in-sample backtesting]… This allows for
     > an apples-to-apples comparison of PnL changes             [3]
     > throughout… A drawdown (DD) at any point should be
     > evaluated as if it occurred from Day 1; this is one          [5]
     > way of interpreting maximum risk.

I will start by describing the concept in lines 4-6 and then cover lines 1-3.

Risk tolerance may be used to determine position size. Suppose the max DD I can psychologically withstand is 10%. Based on the oft-quoted trading adage “the worst DD is always ahead of you,” I should select a smaller position size such as one corresponding to a max DD of 5%. If I now encounter something 2x worse in live trading, my psychology can [hopefully] tolerate it thereby avoiding the potentially catastrophic result of abandoning ship at the darkest moment.

Sticking with the conservative theme, I should also calculate DD as a percentage of initial equity because this will give a larger DD value and a smaller position size. For a backtest from 2001-2015, 2008 was horrific but as a percentage of total equity it might not look so bad if the system had doubled initial equity up to that point.

To say “calculate DD as if it happened on Day 1” is to say any ordering of events is equally likely. A 2011-type correction could have just as well happened in 2002 and a 9/11 could have just as well happened in 2008, etc. In case this is true, I prefer not to trade real money based on the overstated conclusion that a DD occurring later was destined to occur later. Monte Carlo simulation can randomize the trades to generate a large number of potential trade sequences for a trading system. I can then look at averages and standard deviations for things like net income and max DD to get a broader perspective of what to expect in live trading.