Drawdown in Trading

Most (if not all) traders want to rule the market. It would be perfect not to have a single loss, unwise decision, or emotional trade. Unfortunately, it is impossible to forecast every market movement and trade without mistakes. In both trading in investing, there are periods of losses, or as they can be called drawdowns. This article will guide you through definitions and explanations of drawdowns. Prepare to be educated, and let's start!

What is a Drawdown in Trading?

When it comes to forex trading, drawdown refers to the difference between a high point in the balance of your trading account and the next low point of your account's balance. The difference in your balance reflects lost capital due to losing trades. As for the investment process, drawdown is the difference between your portfolio's maximum and the minimum.

For example, you decided to invest in stocks and cryptocurrencies. So you bought Tesla, Moderna, Bitcoin, and Ethereum. They are all volatile. Moreover, all of these assets suffer from news and geopolitical concerns. Let's assume you invested $10 000. Each asset covers 25% of your portfolio. At some moment, you have $14 000. And at some other moment, you find out to have only $9000. So your drawdown will be $5000 ($14K - $9K). But we will talk about the calculations later.

Thanks to the drawdown, you can get the level of your diversification and risk appetite. It is an essential part of trading strategy analysis. If the drawdown is too big and you don't like it, maybe it's time to think about improving your strategy or even changing it.

Types of Drawdowns

You should note a slight difference between trading and investing drawdowns. The first is about active management of your trades, and the second is about holding for a long time. However, trading drawdowns are usually way bigger than investment ones. Of course, it all depends on your trading strategy, risk appetite, and diversification. Since we have already figured out two main drawdown types, let's talk about drawdowns in stocks.

A stock's total volatility is measured by its standard deviation (how much the stock can go away from its average price). Many investors, especially retirees withdrawing funds from pensions and retirement accounts, are mostly concerned about drawdowns. Volatility can spoil the process or retiring with unexpected crashes and lengthy recoveries. That's why there is a rule for long-term investors. To manage your portfolio wiser and eliminate unnecessary risks, people divide their investments. Take 100 and subtract your age from it. The number left is the percentage of high-risk assets you should have compared to low-risk ones. For example, if you are 30 years old, you should have 70% (100-30) of risky assets and 30% (100-70) of haven assets in your portfolio. This way, when you get older, you will be less prone to volatility because by 60 years old, you will have only 40% of risky assets (100-60).

Drawdown in Trading vs. Drawdown in Banking

The term "drawdown" appears in both the banking and trading worlds, but it has very different meanings within each context. Within the context of banking, a drawdown commonly refers to the gradual accessing of part or all of a line of credit. The arrangement with a bank can be either personal or business-related. It doesn't sound straightforward, so let's put it simple.

An example of a drawdown for an individual borrower is a car owner who wants to improve his car. But it would be inefficient to borrow all the money at once and put them all into the repair or improvement process. So instead of this, the borrower opens a credit line with the bank and takes only what he wants. Thus, he pays interest on the funds borrowed, not on the whole amount. The process of withdrawing the money from the bank is called the drawdown in banking.

How to Calculate Drawdown in Trading

As we mentioned above, to calculate the drawdown in trading, you need to subtract the low of your portfolio from the high. Let's assume that you have a $100 initial amount, $70 on your lowest and $120 on your highest. Now, the drawdown is calculated from the peak that your account reached ($120) and not from your initial capital ($100). So, in this case, the drawdown experienced is $50 ($120 – $70). Drawdown is measured over a specified period, between two specific dates. Drawdown can be expressed in dollar amounts (as above) or as a percentage.

Thus, the formula for calculating drawdown as a percentage is as follows:

Drawdown (DD) % = ((Pmax – Pmin) / Pmax)) * 100

Pmin = Historical low (trough)

Pmax = Historical high (peak)

Drawdowns refer to the decline of capital in a trader's account, specifically the movement from a particular peak to a specific trough. A trough cannot be defined until a new peak is reached. It is still important to understand that a drawdown is not a loss. A drawdown is simply the movement from a peak to a trough, whereas traders consider a loss relative to the initially deposited amount.

Also, it is crucial to understand that the drawdown is almost always with you. For example, you are a profitable trader, and your peak is at $150 with a trough at $110 (and you started with only $100, a great result). Thus, your total drawdown is $40 ($150-$110). Your portfolio may have returned a profit of 50%, but you have suffered a drawdown of 27% during the same period.

Drawdowns Importance

Drawdowns present a risk to investors regarding how much effort or changes in prices are required to overcome them or return to the initial peak. Therefore, traders and investors calculate it to avoid unreturnable losses.

For example, a 1% drawdown isn't bad, and you only need a 1.01% gain to recover. But a 50% drawdown will need a 100% gain to get your money back. And it is way more complicated if now impossible to do. The percentage you need to recover is called the drawdown risk. For example, for a 20% drawdown, the risk is 25%.

Risk management is essential in the trading and investing process. It is what keeps you in the game. For example, let's assume that you have a fantastic trading strategy with an 80% win rate. But it doesn't mean that you will always win 8 out of 10 trades. Lose streaks are inevitable, and you should address them.

Tips for Reducing Drawdowns in Trading

The main instrument for a trader that will reduce the drawdowns is diversification. Don't put all eggs in one basket. You can stand against the most severe crashes with fewer losses if you diversify your portfolio. For example, having gold in your portfolio will help against inflation and recession periods. Add some stocks to give yourself more growth, and don't forget about oil because as the economy expands, oil gets more expensive due to demand increases. Also, to trade without losses read our article on the theme.

If you are a trader, proper risk management is the best possible tool for you. Keep in mind that even with a profitable trading strategy, a lack of risk management will kill your account. For example, don't enter the trade with too big lot size. Also, try to maintain the same order size for every trade. This way, you will know exactly how much you may lose. More control means fewer drawdowns. 

In a nutshell, here are the three main points of drawdowns.

• They can be expressed in percentages or absolute monetary terms.
• They measure how much a trading account is down from its peak before it recovers again back to the peak.
• Drawdown risk refers to the percentage a trading account must gain to overcome.

Author: FBS Analyst Team

More by this author

Similar

28.12.2022 17:05 How to Trade Three Black Crows Candlestick Pattern

In trading, we can rely on a bunch of different entry signals.

12.12.2022 09:25 How to Trade Triangle Chart Patterns?

A triangle chart pattern is a consolidation pattern that involves an asset price moving within a gradually narrowing range.

14.11.2022 09:10 Forex Trading Plan Example and Definition

Trading has several levels of complexity, starting from the easiest, like buying and selling random assets, to a more comprehensive one, with deliberate risk management, timing, and objectives.