Making the Case for Drawdowns – A Numbers Game
As a regular trader, you will invariably come across many unique terms, phrases, and lingo in the literature. One of the most commonly-used terms in trading parlance is a drawdown. Contrary to perception, this has nothing to do with a Mexican stand-off in in the Wild West. In trading terminology, a drawdown is an important concept which describes the difference between the peak and the trough, in respect of the account value. Let’s say you have invested a substantial sum of money – USD$100,000 in Apple stocks, Google stocks, Facebook stocks, and Twitter stocks at your favourite online broker.
We already know that the tech-heavy NASDAQ composite index in the US is extremely volatile. This means the value of your portfolio is likely to whipsaw wildly over time. It’s entirely possible that you may lose USD$20,000 in double-quick time, before shares bounce back and your portfolio grows in value. Perhaps the recovery takes your portfolio to USD$120,000, followed by another sharp ‘correction’ which reduces your investment portfolio to USD$88,000. During this process, you will have experienced a drawdown of USD$32,000 (USD$120,000 – USD$88,000).
Note that the drawdown is measured over a specific period in time, between two dates. The formula for calculating drawdown is as follows:Drawdown (DD) = min(0,((Pt – Pmax)/(Pmax))
It is important to point out that for drawdowns to be calculated, the portfolio must move back to its original amount of USD$100,000 +.
Once this move has taken place, the drawdown is recorded. Drawdowns in trading activity refer to the decline in equity in a trader’s account. More specifically, a drawdown in trading refers to the movement from a peak to a trough to a new peak. This precise definition of a drawdown in trading is necessary because a trough cannot be defined until a new peak is reached, or the portfolio returns to its original high value. In simple terms, drawdowns are expressed as a percentage.
If you have USD$100,000 and you lose USD$15,000, you have experienced a 15% drawdown. Even if your trading account is profitable, you can still experience a drawdown. Following on from the same example, your USD$100,000 may have grown to USD$150,000, then suffered multiple losses, reducing your account balance to USD$125,000. Note that you’re still USD$25,000 higher than your original portfolio value of USD$100,000, but down USD$25,000 from your peak! As a trader, you might want to look at the USD$25,000 figure as a profit of 25% (off your starting capital), not a loss of 16.7% (off your USD$150,000).
Another important concept vis-a-vis a drawdown in trading relates to the duration of the timeframe. Any time there is a drawdown, the time it takes to restore your account/portfolio to its original capital value is known as the drawdown duration. If it took 3 months for your account to move from USD$100,000 to USD$150,000, and then to USD$125,000, you would have experienced a 3-month drawdown.
Why are Drawdowns Important in Financial Matters?
Risk is an important component of investments. With drawdowns, it is easier to determine the level of financial risk involved in an investment. Risk/reward ratios provide insights to shares traders, commodities traders, and currency traders. Let’s take a rudimentary example to illustrate the effects of price movements on shares on the ASX. Assuming a share of company ABC drops from USD$50 to USD$40, and then rallies back to USD$50.01 +. The drawdown in this case is USD$10 or 20%, from the peak.
Important notes for drawdowns:
- They are usually quoted as a percentage, or in USD
- They typically measure downside volatility with assets
- A loss is not the same as a drawdown since it is still possible to have a drawdown and make a profit on invested capital
- Drawdown Risk refers to the percentage that a financial instrument must appreciate in order to overcome the effects of a drawdown. If a share drops 1%, it needs to recover 1.01% to hit its prior peak, but a drawdown of 50% requires a 100% increase to reach its prior peak**(USD$100 USD$50 = 50% drawdown. But 50% increase on USD$50 is only USD$25, so 100% increase of USD$50 is needed to reach prior peak!)
All That Glitters – Example of a Drawdown
Let’s assume that you make an investment in a commodity like gold, with a price of USD$1,000 at its peak and USD$800 at its trough. Along the way, the price rises back to USD$1,110. Your drawdown is not based on your initial price and the trough; it’s the price differential between the peak and the trough. In this case, the high price of USD$1,110 is measured against the low price of USD$800, for a drawdown of USD$310. To calculate the percentage, we must take USD$1,110/USD$310 = 35.81% drawdown.
Remember: drawdowns move across timeframes, so these must be defined in order to calculate the correct drawdown for each trading period. In the banking world, drawdown has an entirely different meaning to drawdown in trading. Let’s say you have been approved for a HELOC (home equity line of credit) from your local bank. If your bank approved you for USD$50,000 in home equity credit, you could use up to USD$50,000 for whatever you wish to do. However, in the context of banking your drawdown is based upon how much of that line of credit you’re actually accessing.
By restricting the amount of credit you are accessing, you are also limiting your indebtedness to the bank.
If you were to borrow all of the money – USD$50,000 – all at once, you would be liable for the interest-related charges, fees, and commissions on that full amount. It is possible to have a drawdown for business or personal use in banking matters. Drawdown requests are official applications to withdraw funds from your line of credit a.k.a. personal loan, business loan, or home loan. These requests are relatively easy to make by simply filling in the borrower’s details, the loan drawdown details, and signing the declaration. This is a request for an advance on money that has been earmarked for the borrower.
A drawdown is an important cog in the wheel when assessing your overall level of risk. This tool tracks the volatility of pricing over time, and when used in the Calmar ratio (total price return / maximum drawdown of portfolio), can be an invaluable resource for determining whether or not you should make a trade or investment. As you now know, the risk and return of any financial instrument can change at any time. Most portfolio managers adopt an eclectic approach to managing risk, with many technical factors to consider. The bigger the expected return on an investment or trade, given market risks and drawdown realities, the better the investment or trade.
In summary: You can easily calculate the drawdown on your shares, commodities, or currencies by marking the high values and low values over a period of time. Mark off the recent high and the recent low. Subtract the low value from the high value and then divide that by the high value. That’s the drawdown!
Drawdowns main FAQs
- What is a good drawdown?
The answer to this question is entirely dependent on the risk tolerance of the person asking. In general, however it is considered good to keep the drawdown below 20%, and even better to keep it below 10%. Of course, the total return of an account shouldn’t be adversely affected by too much when limiting drawdowns, otherwise profits are sacrificed in favour of comfort. Because a drawdown is merely a measure of volatility in the trader’s account there shouldn’t be a problem with a drawdown of 20%, although a larger drawdown would almost certainly make the investor uneasy as it puts too much capital at risk.
- What is the difference between drawdown in trading and drawdown in banking?
The term drawdown is used in both the banking industry and the trading world, however the meaning of the term in each case is quite different. When referring to drawdown in trading the meaning is a reduction in the equity value of the account. Most commonly it is the difference between the high and low points of the account value over a set period of time. In the banking world a drawdown is the gradual access of part or eventually all of a line of credit.
- How can you reduce your drawdown?
One often overlooked method for reducing drawdown in an account is to diversify investments. This strategy has been shown to dramatically reduce the drawdown while having little impact on the performance over a period of time. Another way to reduce drawdown is to lower your use of leverage since leverage magnifies the price movements of assets. It has also been found that by decreasing your holding length you can decrease your drawdown, in other words be a trader, not an investor. If you’re trading you don’t want to have long holding periods, and if you’re an investor you’ll hold for an exceptionally long period of time, which allows you to weather any excessive drawdowns.
Register at AvaTrade and put your drawdown experience to the test now!