Today’s article discusses a drawdown. What is it? How to assess it and what do you need it for? The answers to these questions you will find below.
Contents
The drawdown description
In the trading world, the drawdown is a decline from a peak to a trough over a certain period of time for a specific fund, account or investment. It indicates how much a fund, account or investment is down from one peak before it reaches the peak again.
Usually, it is quoted as a percentage, however, for some traders dollar terms can be used.
You may think that the drawdown is equivalent to a loss, but it is not. A drawdown is a peak to a trough decline and the loss is the difference between the buying price and the current or exit price.
The drawdown assessment
In the drawdown assessment, a trader should also take the time needed for recovery from the drawdown into consideration.
For the drawdown to be recorded, you have to wait until the price reaches the peak again. Until then anything could happen like a lower trough for example. So as long as the price persists below the old peak, the drawdown remains in effect.
Let’s use an example of an account with $10,000 in it. Assume that the capital drops to $9,000. We cannot measure the drawdown before there is more than $10,000 in the account anew. Only when the amount is bigger than $10,000 we can record a 10% drawdown.
If the account reaches $120, falls to $90 and rises to $125 afterwards, we get a new peak at $120 and a new trough at $90. This gives us a $30 drawdown or $30/$120 = 25%.
What you can use the drawdown for
With drawdowns assessed you have a chance to measure the risk of different investments through history. You can also compare the performance of funds as well as monitor your own trading performance.
The drawdowns are used by the Sterling ratios to compare the potential return on security with the risk.
Stock’s standard deviation measures its overall volatility. Drawdowns are the negative half of the standard deviation and a downward volatility measurement. Many traders, especially those in retirement with regular withdrawals, are especially concerned about the high volatility and big drawdowns. They often check the maximum drawdown (MDD) of a specific investment over some time to avoid these investments.
Many traders prefer to avoid drawdowns that exceed 20%. This is because of the volume needed to recover to the previous peak. For instance, a drawdown of 1% requires just 1.01% to recover. But if a stock loses 20%, a return of 25% will be needed. And a drawdown of 50%, such as during the Great Recession in the years 2008 and 2009, needed as much as 100% increase.
Summary
A drawdown is a decline from a peak to a trough over a specific period of time before the price comes back to the peak. It cannot be measured before it happens. It is generally advised to avoid drawdowns that are bigger than 20%. Nevertheless, you must assess what is best for you. For example for retirees, which do not have years for waiting until recovery occurs, another limit should be set.
Remember that the time needed for recovery has to be taken into account. Some investments recover faster than others. You ought to view the historical data for a specific investment you are interested in.
You can minimise the drawdown risk by diversifying your portfolio. There are plenty of options to choose from like stocks, commodities, precious metals, cash instruments or bonds.
Trading always involves some portion of the risk. You must be aware of this and take some precautions. Have patience and only begin trading with a calm mind.
Wish you high profits!