Open AccessYou Are in a Drawdown. When Should You Start Worrying?
Author(s) -
Rej Adam,
Seager Philip,
Bouchaud JeanPhilippe
Publication year - 2018
Publication title -
wilmott
Language(s) - English
Resource type - Journals
eISSN - 1541-8286
pISSN - 1540-6962
DOI - 10.1002/wilm.10646
Subject(s) - drawdown (hydrology) , sharpe ratio , point (geometry) , econometrics , economics , computer science , mathematical economics , mathematics , geology , financial economics , portfolio , geometry , geotechnical engineering , aquifer , groundwater
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 note, 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.