EdgeWare FastBreak Pro Version 5 User Manual
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The Effect of MDD Objectives on Performance
All investors want trading systems with a small MDD. Here are the results of a study
that looked at how MDD performance objectives affected both IS and OS performance.
Annual performance was optimized, but MDD constraints of 10%, 15%, and 20% were
also applied. The study used the Select trading family and held three funds. The IS
period was 5/12/1989 to 12/31/1996 and the OS period 1/2/1997 to 9/15/1999. The
optimization was made with three funds. Here are the IS performance, OS performance
and OS MDD:
As expected, the IS and OS performances are reduced when the MDD goal is made
smaller. This is a very common observation with trading systems. Risk avoidance
typically has a negative effect on performance. The same impact to performance is seen
in the OS results. System developers need to know the performance-risk ratio when they
design systems, and making a few runs similar to these can show that affect. In our
example, we see approximately 10% annual reduction in performance (IS and OS) as we
try to reduce the MDD from 20% to 10%. The close relationship between IS and OS
return is very encouraging, especially when we consider that the OS period is nearly
three years long. We have overlaid the OS MDD values on the chart – solid triangle
symbol. An unfortunate observation is that we were not as successful with maintaining
the MDD in the OS. This is not unexpected because: A) Select funds are very volatile,
B) the OS period included the very severe 1998 bear market, and C) we didn’t use market
timing. There is an option we can use to help improve our results. We have found that
system OS performance is hurt if several stop options are activated. This is exactly what
happened when we tried to build a system with a 10% MDD. We have put an option in
FastBreak Pro that applies a penalty to systems that activate several stops. FastBreak Pro
will now “avoid” trading systems that activate too many stops. The above example using
20
25
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40
5
10
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MDD Goal, %
Return, %/year
IS
OS
OS MDD
SP
OS
MDD
IS