What Is Drawdown?
Investing is a risky game. However, it has its perks—especially for traders who are knowledgeable about how to play the stock market. But of course, highs and lows are normal in the trading world. To help you maintain your profits, drawdown calculation is essential.
Are you curious to learn more about drawdowns? If so, continue reading below.
What Is Drawdown?
When it comes to investing, risk management is a key part of trading, and it helps investors stay in the game. In most cases, traders find different ways to gain an advantage in the market. While strategizing is good and knowledgeable investors have an 80% success rate, there are times when they aren’t profitable.
It’s inevitable to go through periods of experiencing a losing streak. In those circumstances, drawdowns are essential. A drawdown defines the degree in which your training platform or investment plummets from its peak before recovery. Basically, it’s the peak to valley decline during a particular period of time.
This is calculated by the percentage between the peak and the decline. However, when it comes to trading account value, the drawdown can also be the dollar amount. Let’s say if you have $2,000 in your trading account and it drops to $1,000. Then, it moves back up and exceeds $1,000. In that case, the drawdown is 10% or $100.
On the other hand, if the price value of your account declines to a peak low and never comes back up, you can expect an even lower trough. However, troughs are only a factor if there is a new peak.
Here are some of the basics of drawdowns:
- They calculate how much a trading account is down from its peak before it bounces back to the peak
- They are described in percentages as well as monetary terms
- Drawdown describes the percentage that a trading account must gain to recover from the damage created by a drawdown
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What Is Drawdown in Trading?
In the trading world, drawdowns are vital because they help traders calculate the historical risk of instruments and examine their performance. For instance, the drawdown of a stock can determine how risky it was in the past. By knowing this information, traders can determine whether or not a specific instrument complies with their risk tolerance and overall investment goals.
Furthermore, drawdowns are described as downside volatility. The larger the instrument is, the more volatile that particular instrument is likely to be.
When calculating a draw down based on an instrument price or an account value, it’s important to remember that it takes time to recover from a drop. The faster that it takes for an instrument to bounce back to its price, it’s more of a perk for the trader.
However, drawdowns have different timeframes. If a stock goes down, it could get back to its peak within minutes during what’s called a flash crash. Those aren’t much to worry about.
However, sometimes it could take several months for things to recover depending on the market.
The Different Types of Drawdown
As you’re measuring potential loss of capital, there are different types of drawdown methods for calculation. Here are the different types of drawdown:
Relative drawdown is an unidentified loss. When the drawdown is temporary and you hold on to your position, it usually goes unnoticed until your stop loss is triggered. For the most part, you have to pay very close attention to your account to notice a relative drawdown.
Maximum drawdown is the highest peak to trough decline within your account balance. The maximum peak equals an all time account high, and then maximum trough is the all-time account equity low.
Basically, the maximum drawdown calculates the distance between the highest account value and the lowest account value over the whole trading account time frame.
Absolute drawdown measures how big the loss is in comparison to the initial deposit. When the account value drops underneath the initial deposit, absolute drawdown comes into play. You’ll calculate the difference between the first deposit and the account equity trough below that level.
How to Minimize Drawdown
It’s vital to determine your risk and decide when’s the best time to minimize your drawdown level. The first method that investors use to reduce drawdown is to disperse their portfolios. This is one of the main reasons why mutual funds are significantly diversified.
They forgo a potentially high profit for a more stable portfolio. This keeps things leveled. Also, another way to minimize your drawdown is to lower the level of leverage. This is especially true in markets where the leverage levels are as high as 1:1000.
However, leverage is a bit tricky because it widens profits just as much as it amplifies losses. In the trading world, holding positions for extended periods of time often exposes the portfolio to the market and increases drawdowns.
Thankfully, this situation can be solved by using lower stake amounts and trading sizes. It’s also a good idea to invest in risk control tools, like stop losses.
Understanding Drawdown Calculations
Hopefully this article helped you understand more about how to calculate a drawdown. By knowing this information, you can remain calm when your investments go through highs and lows. The objective of trading is to put your all into the instruments that’ll produce the most profit.
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