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Major risk analysis indicators

Concept of "risk analysis". Recovery factor and maximum drawdown

In the Introduction to Trading, we cannot make an in-depth study of a rather abundant material related to this subject. We will only note that the risk analysis is an independent branch of science that is based primarily on mathematics and statistics. The research conducted in this area allows us to draw some conclusions about the results that may be expected from the system in the future based on the available data about transaction results, i.e. of statement.

Here, we will discuss (only to illustrate) two important indicators:

  • Maximal drawdown, MDD
  • Recovery factor, RF

The two indicators taken together can indicate whether the system can be expected to return, at least, to the initial level of the balance after a drawdown. Let’s discuss this in more details.

MIDD (maximum intra-day drawdown) indicator was initially used at the stock market where trading is conducted in sessions (for example, from 9 a.m. to 6 p.m. according to the time zone where the stock market is situated). Taking into account the fact that all transactions should be closed at the end of the day, this indicator could be interpreted as the maximum drawdown over the whole period of trading.

Take a look at the illustration.

Figure 18. Maximum growing drawdown

Here we can see that the change in balance progressed as follows. Up to point A, there was a more or less stable growth of the deposit with relatively small drawdowns that are of no importance to us. At point A, there was the first significant drawdown that, however, was not the maximum growing drawdown, because afterwards (after a small recovery) the level of balance continued to decrease, and at point B another local minimum was reached. Nevertheless, point B is not the maximum drawdown either. At point C, the deposit reached the absolute minimum of the whole history of trading, and MDD is the distance from the local X maximum (blue line).

What you should pay your attention to. Here, we are not going to discuss the theory of probability; let’s us make a note, however, that any sensible person understands intuitively. If there was a series of unprofitable transactions that led to the drawdown at point A, then the analyst who analyses the graph should think what would happen if, for example, similar situation re-occurs twice. At point В, there is the second drawdown notable by the fact that after the first drawdown the balance has not fully recovered. The third drawdown (at point C) was less deep; however, it also happened before the balance could recover up to point X.

At this point, we need to bring in the second indicator, recovery factor. It is the ratio of the absolute profit (over the whole period) to the maximum drawdown, i. e.:

This indicator reflects indirectly the ability of the system to recover after drawdowns, and, consequently, its stability and efficacy. The majority of analysts share the opinion that the recovery factor of 1.6 is a threshold value. If the system shows the recovery factor of more than 1.6, it can be regarded as stable and effective. If the recovery factor is less than 1.6, there is a high probability of losing the deposit, as the speed of system recovery after drawdowns may not be high enough.

To finish this section, we will note that the two indicators discussed herein are the most general method to analyse system work results using the statement available. However, this method is rather simple and effective. Those who are interested can refer to the list of references for more information.