Lake Ratio: Measuring Total Underwater Drawdown

Key Takeaways

• The lake ratio is the area below past equity peaks divided by the area under the equity curve.
• It counts the depth and duration of every drawdown, not only the single worst decline.
• A strategy with many shallow drawdowns can score better than one with a few deep ones.
• Lower lake ratios mean the equity curve spends less time and depth underwater.

What the Lake Ratio Is

The lake ratio was devised by trader Ed Seykota as a way to judge trading systems on the full pain of their drawdowns. It earns its name from a vivid mental picture.

Imagine pouring water onto an equity curve from above. Wherever the curve sits below a previous high, water pools into a lake. The deeper and longer the drawdown, the bigger the lake. The lake ratio compares the total volume of all that water to the total area of solid ground under the equity line. A curve that climbs steadily with few setbacks holds little water. A curve riddled with declines holds a lot.

The Intuition

The maximum drawdown answers one question: how deep was the worst hole? It says nothing about how often you fell into holes or how long you stayed there. Two strategies can share an identical maximum drawdown while one recovers quickly and the other languishes underwater for years.

The lake ratio fixes that blind spot. By summing the area of every underwater stretch, it rewards quick recoveries and punishes long, grinding declines. A system that drops 30% once but recovers fast may hold less total water than a system that repeatedly sags 10% and crawls back slowly. This is precisely the case where the lake ratio and the maximum-drawdown-based MAR ratio disagree.

How It Works

The lake ratio is a ratio of two areas measured on the equity curve over time:

lake ratio = area of water (below running peaks) / area under the equity curve

Where:

water area = sum over time of (running peak value - current value)
curve area = sum over time of current equity value

At each point, the running peak is the highest equity reached so far. The water at that point is the gap between the running peak and the current value. Whenever the curve is at a new high, the water is zero. Summing the water across the whole period gives the numerator. Summing the equity values gives the denominator.

Because both pieces are areas, the lake ratio captures duration automatically. A drawdown that lasts twice as long adds roughly twice as much water, even if its depth is the same. That time sensitivity is what sets it apart from depth-only measures.

Worked Example

Consider a simplified track with equity values over 5 periods: 100, 90, 95, 100, 110.

Running peaks at each point: 100, 100, 100, 100, 110.

Water at each point (peak minus value): 0, 10, 5, 0, 0. Total water = 15.

Curve area (sum of values): 100 + 90 + 95 + 100 + 110 = 495.

Lake ratio = 15 / 495 = 0.030, or about 3.0%.

Now suppose a second strategy reached the same endpoints but stayed depressed longer: 100, 90, 88, 92, 110. Water becomes 0, 10, 12, 8, 0 = 30, with curve area 480, giving a lake ratio of 0.0625, or 6.3%. The second curve spent more time and depth underwater, so its lake ratio is higher even though both ended at 110.

Common Mistakes

1. Confusing it with maximum drawdown. The lake ratio measures total underwater area, not the deepest point. A low maximum drawdown can still produce a high lake ratio if recoveries are slow.

2. Ignoring the sampling frequency. Areas depend on how often you sample the curve. Daily and monthly data give different absolute areas, so compare only like with like.

3. Reading it as a return measure. The lake ratio describes the shape of the drawdown experience, not how much money was made. Pair it with a return figure.

4. Forgetting it favors fast recoveries. A system tuned to recover quickly will score well even if it takes large hits. That can mask the size of individual losses, which a depth measure would flag.

5. Comparing across very different horizons. Longer records accumulate more underwater periods. Normalize or compare equal-length windows for a fair read.

Frequently Asked Questions

What is the lake ratio in simple terms? The lake ratio measures how much total area an equity curve spends below its prior highs, divided by the area under the curve. Lower means less time and depth underwater.

How does the lake ratio affect investment decisions? It helps you choose between strategies whose worst drawdowns look similar but whose recovery speeds differ. A lower lake ratio signals a smoother, faster-recovering ride.

What is a real-world example of the lake ratio? Two funds both fall 20% at their worst. One bounces back in months and the other stays down for two years. The slow one has a much higher lake ratio despite the same maximum drawdown.

How can investors use the lake ratio effectively? Use it alongside maximum drawdown and a return measure, keep the sampling frequency and horizon consistent across funds, and treat a rising lake ratio as a sign of sluggish recoveries.

How is the lake ratio different from maximum drawdown? Maximum drawdown records only the single deepest decline, while the lake ratio sums the depth and duration of every drawdown. The lake ratio penalizes long underwater stretches that maximum drawdown ignores.

Sources

1. Trading Blox. "Seykota's risk management web page (Lake Ratio description)." https://www.tradingblox.com/forum/viewtopic.php?t=247
2. Precision Trading Systems. "The Lake Ratio." https://precisiontradingsystems.com/lake-ratio.html
3. Extrategic Dashboard. "Equity Curve." https://extradash.com/en/learn/performance-stats/equity-curve/
4. Managed Futures Investing. "Analyzing a CTA's Daily Returns, Part Two: Equity Curve vs Underwater Chart." https://www.managedfuturesinvesting.com/analyzing-a-ctas-daily-returns-part-two-equity-curve-vs-underwater-chart/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.