youve all have heard me talk about my favorite trading system statistic, what i used to call "annual return vs. max drawdown".

i got around to reading "Trading Risk" by Grant. whaddya know, this is his favorite statistic also. he calls it ROMAD. i like this name better

it got me thinking about ROMAD, and trying to visualize why it is the most important statistic. its incredibly simple, yet still took me a moment to grasp.

the reason ROMAD it is the most important stat is because it mathematically defines risk vs. reward (actually, it defines reward vs. risk, but its the same difference). if you think about it, what is the risk of a system? its the max drawdown! and as most of us are trading for bottom line results, reward IS annual return. annual return divided by risk = ROMAD.

heres an example...

a rational (and i use that term loosely ) investor will have a maximum amount they are willing to risk. lets say you have a 10k account, and the maximum you want to risk on the total system is 3k. in other words, you are willing to bear a 30% drawdown before you quit using the system.

with this in mind, pretend you have two systems to choose from.

systemA / ROMAD = 1.8

systemB / ROMAD = 1.0

since we are only willing to risk 30k, no matter which system we choose, systemA will give us 80% higher annual returns than systemB. because for every one dollar risked (in the form of maxDD) you get back $1.80 back (in the form of annual return) with systemA. and for systemB you only get back $1 for every $1 risked. thats a complicated way of saying systemA has a better risk vs. reward!

ROMAD = avg. annual return / max drawdwon

ROMAD = REWARD VS. RISK

i got around to reading "Trading Risk" by Grant. whaddya know, this is his favorite statistic also. he calls it ROMAD. i like this name better

it got me thinking about ROMAD, and trying to visualize why it is the most important statistic. its incredibly simple, yet still took me a moment to grasp.

the reason ROMAD it is the most important stat is because it mathematically defines risk vs. reward (actually, it defines reward vs. risk, but its the same difference). if you think about it, what is the risk of a system? its the max drawdown! and as most of us are trading for bottom line results, reward IS annual return. annual return divided by risk = ROMAD.

heres an example...

a rational (and i use that term loosely ) investor will have a maximum amount they are willing to risk. lets say you have a 10k account, and the maximum you want to risk on the total system is 3k. in other words, you are willing to bear a 30% drawdown before you quit using the system.

with this in mind, pretend you have two systems to choose from.

systemA / ROMAD = 1.8

systemB / ROMAD = 1.0

since we are only willing to risk 30k, no matter which system we choose, systemA will give us 80% higher annual returns than systemB. because for every one dollar risked (in the form of maxDD) you get back $1.80 back (in the form of annual return) with systemA. and for systemB you only get back $1 for every $1 risked. thats a complicated way of saying systemA has a better risk vs. reward!

ROMAD = avg. annual return / max drawdwon

ROMAD = REWARD VS. RISK

Relax and be happy.