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Let's say that I'm trying to evaluate a FX trading system. I know how to calculate the largest drawdown during a period of time, but how can I calculate the average drawdown or the average largest drawdown in the same period of time?

I thought about using the Sterling Ratio.

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    What does 'average largest' mean, exactly? – JTP - Apologise to Monica Apr 23 '13 at 0:59
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    I don't know @JoeTaxpayer. I'm trying to use the Sterling Ratio link and it uses Average largest drawdown – Jose S Apr 23 '13 at 18:00
  • "Typically the time period is over 3 years and only the largest individual drawdowns are included (e.g. 3 or 5)" - suggesting the 3 lowest points get averaged. I appreciate the link, I'd never heard of this method before. – JTP - Apologise to Monica Apr 23 '13 at 18:35
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    This question appears to be off-topic because it is not directly related to personal finance – Dheer Sep 27 '13 at 9:41
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Contextualization

First of all, I think I'll clear off some confusion in the topic. The Sterling Ratio is a very simple investment portfolio measurement that fits nicely to the topic of personal finance, although not so much to a foreign exchange trading system.

The Sterling Ratio is mainly used in the context of hedge funds to measure its risk-reward ratio for long term investments. To do so, it has been adapted to the following in order to appear more like the Sharpe Ratio:

AdaptedSterling

I Suppose this is why you question the Average Largest Draw-down. I'll come back to that later.

It's original definition, suggested by the company Deane Sterling Jones, is a little different and perhaps the one you should use if you want to measure your trading system's long term risk-reward ratio, which is as followed:

OriginalSterling

Note: Average Annual Draw-down has to be negative on the above-mentioned formula.

This one is very simple to calculate and the one to use if you want to measure any portfolio's long-term results, such an example of a 5 or 10 years period and calculate the average of each years largest drawdown.

To answer @Dheer's comment, this specific measurement can also be used in personal investments portfolio, which is considered a topic related to personal finance.

Back to the first one, which answers your question. It's used in most cases in investment strategies, such as hedging, not trading systems. By hedging I mean that in these cases long term investments are made in anti-correlated securities to obtain a diversified portfolio with a very stable growth. This one is calculated normally annually because you rely on the Annual Risk-Free Rate.

Answer to Your Question:

Having that in mind I think you can guess that the Average Largest Drawdown is the average between the Largest/Maximum Drawdown from each security in the portfolio. And this doesn't make sense in a trading system.

Example:

If you have invested in 5 different securities where we calculated the Largest Draw-down for each, such as represented in the following array: MaxDD[5] = { 0.12, 0.23, 0.06, 0.36, 0.09 }, in this case your Average Largest Draw-down is the average(MaxDD) that equals 0.172 or 17,2%

If your portfolio's annual return is 15% and the Risk-free Rate is 10%, your Sterling Ratio SR = (0.15 - 0.10)/0.172, which result to 0.29.

The higher the rate better is the risk-reward ratio of your portfolio.

Note:

I suggest in your case to only use the original Sterling Ratio to calculate your long-term risk-reward, in any other case I suggest looking at the Sharpe and Sortino ratios instead.

  • I had to recently study all this I'm working on a platform for developing trading algorithms so I need to know all this as the palm of my hand. ;-) – CMPSoares May 9 '14 at 13:53
  • Btw. You should edit your question for qualitative purposes because you don't specify that you want to use the Sterling Ratio which is only added to the comments. – CMPSoares May 9 '14 at 14:11
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    Sounds good @CMPSoares. Do you have any book/resources recommendation for these topics? – Jose S May 20 '14 at 13:29
  • What topics are you referring to, @JoseS, to be more precise? I read a lot on the internet, google scholar to be accurate, some on MOOC courses, like coursera, financial websites. And am planning to study finance alongside my Computer Engineering course. – CMPSoares May 20 '14 at 16:45

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