Learn about one of your worst enemies (drawdown) and
how to fight it.
Reading Time: 3 minutes Financial activity: Trading/Investing Knowledge level: Beginner
Summary
What is drawdown
The different types of drawdown
Some strategies to reduce drawdown in trading
Conclusions
What is drawdown
Drawdown is a term used in financial trading and
investing to measure the peak-to-trough decline during a specific period for a
trading account or an investment.
The decrease can be expressed as a percentage between
the next high and low.
For example, if a trading account has 10,000 USD and
the amount drops to 9,000 USD before rising again above 10,000 USD, then the
trading account views a 10% drawdown.
The different types of drawdown
There are different types of drawdown in financial
trading and investing.
Here are some of them:
1. Absolute drawdown. This type of drawdown measures
the difference between the initial investment and the lowest point of a trading
account or a fund. So, absolute drawdown uses your initial capital as a
reference point. Imagine you deposit $5,000. Your portfolio may then rise to
$6,000 (your “equity peak”). Then, your portfolio goes down to $4,000 (your
“minimal equity”). Absolute drawdown is your initial deposit minus your minimal
equity. In this example, that would be $5,000 – $4,000 = $1,000 (your absolute
drawdown).
2. Maximum drawdown. Maximum drawdown uses your equity
peak instead of your initial deposit to calculate your loss. Using the same
example as above, your equity peak is $6,000, and your minimal equity is
$4,000. So, your maximum drawdown is your maximum peak minus your minimal
equity. In this case, your maximum drawdown is $2,000.
3. Relative Drawdown. This type of drawdown measures
the percentage decline from the highest point to the lowest point of your
trading account (or your investment); for this reason, relative drawdown is
also known as the maximum drawdown percentage. In the above example, your
maximum drawdown is $2,000, and your maximum peak is $6,000. Dividing
2,000/6,000 you get 0.333. Then, multiply by 100 to arrive at 33.3%. This shows
your relative drawdown.
Some strategies to reduce drawdown in trading
It is important to understand how to deal with the drawdown
and how to reduce its harmful effects. Below I propose the most common
strategies in this regard.
1. Diversify your portfolio (and trade many
non-correlated markets). One way to reduce drawdown is to diversify your
portfolio across different markets, time frames, and systems. This can help
reduce the impact of drawdowns in one particular market or system. Trading many
markets with low correlation can help reduce trading drawdowns.
2. Reduce your position size. Another way to reduce
drawdown is to limit your position size relative to your total account size.
This can help reduce the impact of a single trade. It's better to earn a little
than lose a lot!
3. Set max loss amounts (set a cap). You can set
maximum loss amounts on a time basis (for a day, week, or month). This can help
you reduce the impact of drawdowns on your portfolio.
4. Stop your trading activity. Some traders want to
increase their risk to make back their losses. This is called “revenge trading”
and will destroy your account. If you continue to experience losses, sometimes
it's better to take a break. If don’t trade, you cannot experience drawdown!
Conclusions
Understanding the different types of drawdown can help
traders/investors assess the extent of risk associated with a particular
investment/trade and make informed decisions.
It is important to understand how to deal with the drawdown
and how to reduce its effects by applying the right strategy.
A sincere wish of good work to all!
Written by F. GRAMOLA (*).
(*) Member of S.I.A.T., the Italian Society of Technical Analysis (member society of I.F.T.A. – International Federation of Technical Analysts).
Warning
We merely cite our personal opinions for educational purposes only.
All trademarks are the property of their respective owners.
Investing and trading are risky. Don't invest or trade money that you cannot afford to lose.
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