Sharpe ratio is the most widely accepted measure to quantify the quality and the performance of a

systematic strategy. Most funds select PMs based on the Sharpe of their track record and performance-
based ranking systems also rank participants based on their realized Sharpe ratio.

However, real trading does not know about statistic, and concretely what really matters when evaluating a
live strategy is drawdown, not least because drawdowns can have a significant impact on an investor's
emotional state and decision-making, which can affect the long-term success of their investment strategy.

It's crucial to understand the relationship between the Sharpe ratio and drawdown to accurately gauge the
potential for risk in an investment strategy. The goal of this article is to establish this connection and
provide a clearer understanding of what can be realistically expected in terms of maximum drawdown for a
strategy that aims to deliver a given Sharpe ratio.

The results can assist in evaluating the appropriate moment to discontinue a strategy if the actual
drawdown exceeds what is compatible with the assumed Sharpe ratio.

We'll begin with a simulation of daily standard normal returns, represented by rn. There are 250 trading
days in a year, so we'll generate 250 of these random returns. The equity line is determined by taking the
cumulative sum of the rn. To generate equity lines that correspond to a specified annual Sharpe ratio (S)
and annual volatility (AV), we'll apply a linear transformation to the rn

𝑟′𝑛 = α ∗ (𝑟𝑛 + 𝛽)
𝐴𝑉
𝛼=
√250 ∗ 𝜎
𝜎
𝛽 = 𝐴𝑛𝑛𝑢𝑎𝑙𝑉𝑜𝑙 ∗ −𝜇
√250
Where:

Ε[𝑟𝑛 ] = 𝜇
𝜎[𝑟𝑛 ] = 𝜎

It is easy to see that:

Ε[𝑟′𝑛 ]
√250 ∗ =𝑆
𝜎[𝑟′𝑛 ]
𝜎[𝑟′𝑛 ] = 𝐴𝑉
The cumulative returns of r’n are thus equity lines of Sharpe S and annual vol AV as desired.

By generating N of these lines, study the statistical properties of a random sample with specific
characteristics.
The following is the Python code for generating these paths:

In python the code that generates these paths is the following:

import pandas as pd
import numpy as np
import random
def generate_paths(s,STD,N):
returns = []
for _ in range(N):
returno = np.random.normal(0, 1, 250)
r_std = returno.std()
returno = returno+(s*r_std/np.sqrt(250)-returno.mean())
returno = (STD/(np.sqrt(250)*r_std))*returno
returns.append(returno)
return pd.DataFrame(returns).T

By utilizing this technology, we can delve into the samples to explore the connection between Sharpe ratio
and drawdowns. A drawdown refers to a fall in an investment's value from its peak to trough during a
specific period.

To illustrate this relationship, we run simulations of 40 million paths, calculating the max drawdown for
each generated equity line. The end result is a plotted distribution of max drawdowns, as shown in the
charts for Sharpe ratios 1 and 2.
The final step involves determining the expected and worst-case drawdowns over a specific period, based
on the distribution of max drawdowns, for a given Sharpe ratio. The chart to the left displays the results. On
the right, equity lines corresponding to the most severe drawdowns for various Sharpe ratios are plotted to
give the reader a visual representation of how steep the drawdowns can be, even with a relatively high
sharpe.

The table below can assist in real-time trading by determining when to stop a strategy. If a strategy with a
projected Sharpe of 1 incurs a loss exceeding 2.35 times the annual volatility, the assumption on the Sharpe
ratio becomes invalid, and it may be advisable to discontinue it.

Sharpe Ratio 0 0.5 1 1.5 2 2.5 3 3.5 4

Expected Max drawdown in Annual Vol 1.08 0.91 0.79 0.70 0.62 0.56 0.51 0.47 0.44
Worst drawdown in Annual Vol 2.79 2.58 2.35 2.18 2.00 1.86 1.72 1.60 1.49