Any trader will have learnt that patience is one of the most important attributes to have in the market. But being too patient can also have its downsides, which is why it is important to understand the various dynamics and variables that can signal to you when enough is enough. This is why analysing drawdowns is very important for any trader. In financial trading, a drawdown refers to how much an account has fallen from its peak to its trough in terms of the capital or investment amount. Consider this: You invest a substantial amount of money, $100,000, in a portfolio of tech stocks such as Facebook, Google, Twitter and Apple. Tech stocks are known to be particularly volatile, and this will be reflected in your portfolio as well.
Your account is likely to witness whipsaws as share prices of the underlying stocks fluctuate in the market. Let’s say that the volatility sees your account dip to $90,000, but a previous uptrend pushed your account to peak at $120,000. Now, the drawdown is calculated from the peak that your account reached ($120,000) and not from your initial capital ($100,000). So, in this case, the drawdown experienced is $30,000 ($120,000 – $90,000). Drawdown is measured over a specified period, between two distinct 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, or more specifically, the movement from a particular peak to a particular 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 amount of the initially deposited amount as capital.
It is possible to have an overall profitable portfolio but still suffer a drawdown. Consider this: You have a $100,000 account which you grow to $150,000. After that, you experience a series of losing trades that leave your account with $125,000. Your account is still profitable ($25,000 in profits from the initial capital of $100,000), but you have also suffered a drawdown ($25,000 from the peak of $150,000). Your portfolio may have returned a profit of 25%, but during the same period, you have suffered a drawdown of 16.7%. Drawdowns present a risk to investors in terms of how much effort or changes in prices are required to overcome them or return to the initial peak. This is why investors watch drawdown keenly and change trading strategies when things threaten to get out of hand. For instance, a 1% drawdown will not raise any worries because it only requires ~1.01% gain to overcome it. But a 50% drawdown (losing half your account) will require a 100% gain (doubling your account) to overcome it.
Why are Drawdowns Important in Investment?
Risk management is very important in investing or trading activity. It is what keeps you in the game. When developing a strategy, traders look to have one that gives them an edge in the markets. A strategy that has, say 80% success rate, does not imply that 8 trades out of 10 will be profitable. There will inevitably be periods when there will be a losing streak. This is where drawdowns come in. Drawdowns are very much part of any trading activity, and any risk management plan must detail how to deal with them effectively so as not to endanger the portfolio.
Here are the main takeaways 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. the impact or damage caused by a drawdown. A 1% drawdown represents ~1.01% drawdown risk, which is the percentage the account must gain to recover from the drawdown. A 20% drawdown represents a 25% drawdown risk, whereas a 50% drawdown represents a 100% drawdown risk.
Every investor should know how to assess drawdowns to effectively mitigate the risks it poses. Depending on the asset class you are trading, drawdown risk is curbed by assessing the diversification of a portfolio as well as the effort required to overcome it. A stock trader, for instance, will want to mitigate drawdown risk by diversifying his portfolio across different industries. A cryptocurrency trader will mitigate drawdown risk by balancing between established coins, Stablecoins and altcoins. A forex trader will want to curb drawdown risk by assessing risk exposure to major, minor and exotic currency pairs. Diversifying a portfolio across different asset classes can also help in mitigating drawdown risk.
The recovery window is also a key consideration of drawdown assessment. This is the length of time it takes to recover or overcome the drawdown experienced. The recovery window will vary depending on the type of assets you trade as well as your trading goals. It can take a lot less time to recover drawdowns in CFDs markets, such as Forex, compared to traditional markets, such as stocks and bonds. There is also the aspect of maximum drawdown. Every prudent investor will have a maximum drawdown level for their account or portfolio. When that level is about to be met, the investor can take necessary measures to protect their account.
The measures can be as drastic as changing an entire strategy or as practical as reducing the stake amount, tightening stop losses or avoiding volatile assets. For instance, consider a forex trader that has set a maximum drawdown of 20%. If the drawdown surpasses 15%, the trader can decide to reduce the lot size traded, or even avoid assets that are considered risky, such as leveraged ETFs and exotic currency pairs. Beyond investing, drawdown can be applied even in the banking world when dealing with credit. For instance, if you qualify for a mortgage of up to $100,000, you could decide to use the entire line of credit or just a portion of it.
If you borrow the full amount available, you will also be liable for interest or any other associated fees and commissions based on the full amount. But if you limit the amount of credit you are accessing, you are also limiting your indebtedness or liability. Thus, in this context, a drawdown request is effectively a loan application, and a drawdown risk is your entire obligation to repay the loan. This goes to show that the concept of drawdown can be applied in both personal and business loans. Assessing drawdown is an important aspect of risk management. Drawdown is assessed based on a specified period and investors can mitigate its risk by setting a maximum drawdown level or effective diversification of a portfolio. A good investment, therefore, is one that, despite market risks and drawdown realities, it is still able to offer a bigger rate of return. The concept of drawdown can be applied across all types of assets as well as in personal and business credit.
What is a good drawdown?
This entirely depends on individual risk tolerance or personality type. An aggressive trader can tolerate a higher-level drawdown, whereas a conservative investor will tolerate a lower level of drawdown. However, it is always recommended for investors and traders that drawdown should be kept below the 20% level. By setting a 20% maximum drawdown level, investors can trade with peace of mind and always make meaningful decisions in the market that will, in the long run, protect their capital.
What is the difference between drawdown in trading and drawdown in banking?
Drawdown has applications in both investment/trading and banking. In trading or investment, drawdown refers to the reduction in equity capital. It is essentially the difference between the peak equity value that your account reached and the lowest equity level reached within a specified period. In the banking world, drawdown refers to the gradual access of part or eventually all of a line of credit. This means that in investment, drawdown determines your risk level, whereas, in banking, drawdown determines your level of liability.
How can you reduce your drawdown?
As mentioned above, it is important to define your risk tolerance and decide when it is time to reduce your drawdown level. The first strategy investors use to reduce drawdown is to diversify a portfolio efficiently. This is one reason why mutual funds diversify extensively. They sacrifice potential higher profitability for portfolio stability. Another way to reduce drawdown is by lowering the level of leverage, especially in CFDs market where leverage levels can be as high as 1:1000. Leverage is a double-edged sword because it magnifies profits as much as it amplifies losses. In the financial markets, holding positions for longer periods exposes a portfolio to market risks that can increase drawdowns. But this can be mitigated by using lower stake amounts or trade sizes. Utilising risk control tools such as stop losses and take profits can also help reduce drawdowns.