What is drawdown in trading?

In the world of trading, managing risk is as essential as seeking profit. Among the many metrics that help traders gauge their performance, drawdown is one of the most critical. But what is drawdown in trading, and how does it affect trading strategies?

Let’s dive into the concept of drawdown in trading and its importance for one’s trading strategies.

First off, what is drawdown?

A drawdown represents the decline from a high point to a low point over a certain period for an investment, trading account, or fund. It’s a key metric for gauging the historical risk of investments, comparing fund performances, or tracking individual trading results. Typically expressed as a percentage from the peak to the lowest point before a recovery, drawdown in trading helps traders see the extent of potential losses.

What is the definition of drawdown in stock trading?

Source: enlightenedstocktrading.com

Drawdown Percentage Calculation:

Drawdown (%) = ((Highest Peak Value (Pmax) – Lowest Trough Value (Pmin)) / Highest Peak Value (Pmax)) * 100

Pmax: Highest historical value (peak) reached by the investment.

Pmin: Lowest value after reaching Pmax (trough).

Interpretation:

Drawdown measures the drop in portfolio value from peak (Pmax) to trough (Pmin) as a percentage, showing the severity of a loss relative to the highest point.

Example:

If a stock peaks at $100, drops to $50 and then recovers, the drawdown is $50 or 50%.

What are the different types of drawdowns?

There are various drawdowns in trading; each gives unique ways to give traders a clearer picture of risk and performance.

Here are some of the classifications of drawdown:

Absolute Drawdown: This represents the loss from the initial deposit to the lowest point in account value, regardless of later peaks. It helps assess overall risk relative to the starting balance.

Maximum Drawdown: The largest observed percentage decline from a peak to a trough over a trading period. It’s used to understand the worst potential loss within the account’s trading history.

Relative Drawdown: This is the percentage loss relative to the highest peak achieved. It helps traders understand the depth of loss in relation to their account’s peak value.

What does the drawdown table show and how to use it?

Furthermore, a drawdown table measures downside risk, helping traders assess expected volatility. By comparing drawdown in trading across strategies, traders can find the best risk-return balance. When building a portfolio, including uncorrelated strategies with independent drawdowns can reduce risk and help smooth returns. Setting acceptable drawdown limits at both strategy and portfolio levels is crucial to managing risk and avoiding prolonged recovery from large losses.

Large drawdowns dramatically limit your ability to recover to new equity highs in your stock trading

Source: enlightenedstocktrading.com

Controlling drawdown in trading is essential because large losses are hard to recover from. Due to the asymmetry of drawdown recovery, a 10% loss requires an 11% gain to break even, while a 50% loss demands a 100% gain. Bigger drawdowns make reaching new equity highs extremely challenging—even a 90% drawdown would be nearly impossible to recover from. Consider not just how much you can lose, but also how long it would take to bounce back.

Examples of drawdowns across markets

Forex: In Forex, drawdowns happen during extended losses in currency pairs, managed by diversifying, using stop-losses, and adjusting positions based on volatility.

Crypto: In Crypto, drawdowns can be sharper due to high volatility. Traders mitigate this by diversifying across digital assets, setting trailing stop-losses, and actively monitoring market news to adapt strategies.

Commodities: In Commodities, drawdowns occur with prolonged price drops in raw materials. Traders diversify across sectors like Energy and Metals and use hedging tools like futures.

Stocks: In Stocks, drawdowns arise from drops in stock prices or indices. Traders diversify across sectors and regions, apply stop-losses, and rebalance portfolios to manage risk.

Read more: How to invest in stocks online: a beginner's guide

Drawdown in banking vs. Drawdown in trading

The term "drawdown" is used in both banking and trading, but it means very different things in each context. While drawdown in trading is a measurement of loss, drawdown in banking is a controlled, expected withdrawal process.

Here’s a side-by-side look at how drawdown in trading differs from banking:

Drawdown in Banking

In banking, a drawdown is the gradual use of credit, allowing borrowers—individuals or businesses—to access funds as needed, minimizing interest costs. For example, a homeowner with a line of credit for renovations only withdraws funds as necessary, paying interest on the amount actually used. Businesses, such as construction companies, may also draw funds in stages with time or project-completion restrictions, ensuring efficient capital use.

Drawdown in Trading

In trading, a drawdown refers to a decline in account equity from a peak to a trough, expressed as a percentage. It measures the drop in value and the recovery time to a new peak, helping traders assess risk. For example, if a trader’s account peaks at $20,000 and falls to $15,000, that’s a 25% drawdown. Duration—the time it takes to recover to the peak—also indicates trading strategy resilience, especially important in leveraged markets like forex.

Drawdown in different trading strategies

Drawdown varies significantly across trading strategies, each with its unique risk profile. Here’s how drawdown impacts different approaches:

Day Trading: In day trading, where trades are opened and closed within the same day, drawdowns tend to be smaller but more frequent. Day traders monitor drawdowns closely, as a series of losses can quickly add up, affecting their overall capital.

Swing Trading: For swing traders, who hold positions over several days or weeks, drawdowns can be deeper. Max drawdown is particularly relevant here, as it shows the potential depth of losses during periods of market volatility.

Long-Term Investing: In long-term investing, drawdowns are generally longer and may require years to recover. Understanding the long-term investing drawdown is crucial, as it reflects the durability of a strategy over time and through market cycles.

Read more: 5 popular online trading strategies

Each strategy has a different tolerance for drawdown in trading. While short-term traders prioritize smaller drawdowns, long-term investors are more focused on the strategy’s resilience over years rather than days.

Impact of drawdown on trading strategies

Drawdown highlights potential risks in a trading strategy. If significant or recurring, it may signal the need for tighter risk management, improved diversification, refined entry/exit points, or adjustments to the strategy's risk tolerance. Monitoring drawdown helps traders optimize strategies for better performance in changing markets.

Conclusion

Drawdown reveals potential losses and the resilience of a trading approach, helping traders evaluate the depth and recovery time of equity dips. By monitoring drawdown, traders can adjust risk management, diversify assets, and make strategy tweaks to improve performance, especially in volatile markets. Whether you're a day trader or a long-term investor, keeping an eye on drawdown ensures you’re prepared for market downturns and set for steady, informed growth.

Disclaimer: amana does not provide investment advice. All investments in financial products carry risk. There is no guarantee of profit on any financial product amana offers, and past performance of a financial asset does not guarantee future returns.