The Drawdown Compass

Prerequisites: Dead Reckoning · Episode 16 — The Doldrums · 18 min read

In Episode 16, the Captain hit the doldrums — six months of flat returns followed by a 28% drawdown. He questioned his system. He questioned himself. The Drawdown Compass would have shown him: given his 52% win rate and 1.2:1 ratio, a 28% drawdown occurs in 23% of Monte Carlo paths. Not common. Not impossible. The compass points to patience, not panic.

THE MEASUREMENT

Drawdown is peak-to-trough decline in equity. But not all drawdowns mean the same thing. A 30% drawdown with a 60% win rate and 2:1 reward ratio is a squall you sail through. The same drawdown with 45% win rate and 1:1 ratio is a leak that sinks ships.

The Drawdown Compass uses Monte Carlo simulation — 1,000 randomized equity curves with your system's parameters — to tell you whether your current drawdown is statistically expected or a signal that your edge has vanished.

THE DERIVATION

Step 1: Probability of N Consecutive Losses

Before simulation, know the theoretical bound. The probability of experiencing N consecutive losses is:

Consecutive Loss Probability

P(N losses) = (1 − W)^N

Where W = win rate. At 50% win rate, the probability of 10 consecutive losses is 0.5^10 = 0.098% — about once every 1,024 trades.

Step 2: Expected Maximum Drawdown

For a system with known edge, the theoretical expected maximum drawdown over T trades is approximated by:

Expected Max Drawdown

E[MDD] ≈ σ × √(π/2) × √(ln T)

Where σ = standard deviation of trade returns, T = number of trades. This is the theoretical bound. Reality is often worse.

Step 3: Monte Carlo Simulation

The Compass generates 1,000 equity curves. Each curve flips a biased coin (your win rate) and assigns a random outcome from your win/loss distribution. The result is a distribution of maximum drawdowns — not a single number, but a probability landscape.

Generate Trade Sequence

For each of 1,000 simulations, generate T trades. Win with probability W. Wins return a random value from your win distribution. Losses return a random value from your loss distribution.

Compute Equity Curve

Start with account A. After each trade, update equity. Track the running peak. Drawdown at any point = (Peak − Current) / Peak.

Extract Distribution

Record the maximum drawdown from each simulation. Sort all 1,000 max drawdowns. The 50th percentile is the median expected drawdown. The 95th percentile is the worst-case you should plan for.

WORKED EXAMPLE

Captain Vance has a $100,000 account, 50% win rate, $300 average win, $200 average loss, risking 2% per trade. He runs 1,000 simulations over 200 trades:

Given

Account = $100,000 · Win rate = 50% · Avg win = $300 · Avg loss = $200 · Risk = 2% · Trades = 200 · Simulations = 1,000

Single Trade Outcome

At 2% risk, avg win = $2,000 (2% × $100K × 1.5R). Avg loss = $2,000. Expectancy per trade = $0. The system is breakeven. The Compass will show high drawdown probability.

With Positive Edge

Same system but avg win = $400 (2:1 ratio). Expectancy = +$400 per trade. Median max drawdown across 1,000 sims = 14%. 95th percentile = 28%. A 30% drawdown is rare but possible. A 40% drawdown signals the edge may be broken.

THE INTERACTIVE CHRONOMETER

Run your own Monte Carlo. Enter system parameters and simulate 1,000 equity curves.

Account ($)

Win Rate (%)

Avg Win ($)

Avg Loss ($)

Risk Per Trade (%)

Number of Trades

Median Max DD

—

50th percentile

Prob > 20% DD

—

from simulations

Prob > 30% DD

—

from simulations

95th Percentile

—

worst case bound

Median Final Equity

—

after all trades

Expectancy

—

per trade

INTERPRETATION

Drawdown Level	Interpretation	Action
Below median	Normal operation. Expected turbulence.	Continue system. Log the data.
Median to 75th %ile	Above average but within normal distribution.	Review position sizing. No system changes.
75th to 95th %ile	Stress territory. Uncommon but not impossible.	Reduce size 25-50%. Verify edge has not degraded.
Above 95th %ile	Statistically anomalous. The compass is broken or the map has changed.	Halt trading. Revalidate entire system.

From the Logs

In Episode 12 — The Last Voyage, the Captain abandoned a proven system after a 22% drawdown. He never computed that his system's 95th percentile drawdown was 24%. He quit one simulation away from the bound. The Compass would have told him: stay the course. The leak was in his resolve, not his math.

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Sextant Guide