Maximum draw-down and directional trading
Maximum draw-down measures the worst drop in a market in a given time period. Jan Vecer shows how to price and replicate this event. Replication can be naturally linked to existing popular trading strategies, such as momentum or contrarian trading
In this article, we introduce new techniques to control the maximum draw-down (MDD). One can view MDD as a contingent claim, and price and hedge it accordingly as a derivatives contract. Trading draw-down contracts or replicating them by hedging would directly address the concerns of portfolio managers who would like to insure against market drops. Similar contracts can be written on the maximum draw-up (MDU). We show that buying a contract on the MDD or MDU is equivalent to adopting a momentum
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