Drawdown
tl;dr
Drawdown measures the percentage decline in an investment’s value from its peak to its trough. It’s an important risk management tool that helps traders and investors understand potential losses. For example, if an investment drops from $100 to $80, the drawdown is 20%. Traders use drawdown to assess their risk tolerance, set stop-loss orders, and evaluate risk-reward ratios. A high drawdown may indicate a risky strategy, while a low drawdown might indicate more stability in the investment.
Definition.
The reduction in account equity from a peak to a trough.
Real-World Example.
Drawdown refers to the reduction in the value of an investment or trading account from its peak to its trough, often used to assess the risk or volatility of an asset. It’s measured as the percentage drop from the highest point to the lowest point during a specific period.
For example, imagine you invested in XYZ Stock. The price rises from $100 to $120 over a few weeks, but then drops to $90 before recovering. In this case:
- The peak value was $120.
- The lowest value during the drop was $90.
- The drawdown is the percentage drop from $120 to $90.
To calculate the drawdown:
- Drawdown = (Peak Value – Trough Value) / Peak Value x 100
- Drawdown = (120 – 90) / 120 x 100 = 25%
So, the drawdown is 25%.
How Drawdown Works.
- Definition:
- Drawdown is the percentage decline in the value of an investment from its peak value to its lowest point. It’s commonly used to measure the risk or potential loss of an investment or trading strategy.
- Max Drawdown:
- Max drawdown refers to the greatest decline from peak to trough in the history of a particular investment. For example, if your portfolio has gone from a high of $100,000 down to $70,000, the max drawdown would be 30%.
- Why Drawdown is Important:
- Risk Management: Traders and investors use drawdown to understand the worst-case scenario for an investment. If an investor can’t tolerate significant losses, a large drawdown might signal the need for a less volatile asset or a change in strategy.
- Evaluating Strategy: It helps to evaluate the risk-adjusted performance of a trading strategy. A strategy with frequent large drawdowns might be risky for some investors, even if it generates high returns.
- Reversal After Drawdown:
- After a drawdown, it’s important to assess whether the investment will recover. Some investments may rebound quickly, while others may take much longer or never recover.
How to Use Drawdown in Trading.
- Risk Tolerance:
- Traders use drawdown to measure their risk tolerance. If you’re comfortable with a maximum drawdown of 10%, for example, you might choose trades or assets that historically don’t exceed that level. Conversely, if you’re more risk-averse, you may prefer investments with smaller drawdowns.
- Risk-Reward Ratio:
- Understanding drawdown is crucial when assessing the risk-reward ratio of a strategy. For instance, if a strategy has a 50% drawdown but offers a 100% return potential, the risk might be too high for some investors, even though the potential reward is attractive.
- Position Sizing:
- Traders often adjust their position size to limit the potential drawdown. If they know the strategy has a tendency for large drawdowns, they might take smaller positions to avoid significant losses.
- Drawdown Recovery:
- One thing to keep in mind is that after a drawdown, you need a larger return to break even. For example, after a 50% drawdown, you need a 100% return just to get back to the original value. This can be a factor to consider in long-term trading and investing strategies.
- Setting Stop-Loss Orders:
- Traders use stop-loss orders to limit drawdowns on individual trades. By setting stop-loss levels at specific price points, they can limit the size of any potential drawdowns and protect their portfolio from major losses.
