When you begin trading an automated system, you normally start in a drawdown. But how can you determine if the drawdown is normal, or if something is wrong and you should pull the plug?
The simplest method is comparing the drawdown with the maximum drawdown of the simulation. A more precise estimate is this:
E >= C + P*t/y - D*sqrt((t+l)/y)
E = your equity
C = initial capital (= Required Capital)
P = test profit
t = trade time
y = test period
D = test max drawdown
l = length of the drawdown
Example: the backtest shows $8,000 profit after 5 years with $2000 drawdown of 1 year length, and $1500 required capital. You invest it and are down to $1000 after 6 months.
E = 1500 + 8000*0.5/5 - 2000*sqrt(1.5/5) = 1204.
With $1000 you're below the minimum profit, meaning that you should pull out.
Keep in mind that this is also just an estimate and does not take into account that the max drawdown can happen anytime, even right at the beginning. So there may be reasons to stop the system earlier, or later.
