Drawdowns in trading why and what to do

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Drawdown and Maximum Drawdown Explained

So we know that risk management will make us money in the long run, but now we’d like to show you the other side of things.

What would happen if you didn’t use risk management rules?

Let’s say you have a $100,000 and you lose $50,000. What percentage of your account have you lost?

The answer is 50%.

This is what traders call a drawdown.

This is normally calculated by getting the difference between a relative peak in capital minus a relative trough.

Traders normally note this down as a percentage of their trading account.

Losing Streak

In trading, we are always looking for an EDGE. That is the whole reason why traders develop systems.

A trading system that is 70% profitable sounds like a very good edge to have. But just because your trading system is 70% profitable, does that mean for every 100 trades you make, you will win 7 out of every 10?

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Not necessarily! How do you know which 70 out of those 100 trades will be winners?

The answer is that you don’t. You could lose the first 30 trades in a row and win the remaining 70.

This is why risk management is so important. No matter what system you use, you will eventually have a losing streak.

Even professional poker players who make their living through poker go through horrible losing streaks, and yet they still end up profitable.

The reason is that the good poker players practice risk management because they know that they will not win every tournament they play.

Instead, they only risk a small percentage of their total bankroll so that they can survive those losing streaks.

This is what you must do as a trader.

Drawdowns are part of trading.

The key to being a successful forex trader is coming up with trading plan that enables you to withstand these periods of large losses. And part of your trading plan is having risk management rules in place.

Remember that if you practice strict money management rules, you will become the casino and in the long run, “you will always win.”

In the next section, we will illustrate what happens when you use proper risk management and when you don’t.

Drawdown Definition and Example

What is a Drawdown?

A drawdown is a peak-to-trough decline during a specific period for an investment, trading account, or fund. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. If a trading account has $10,000 in it, and the funds drop to $9,000 before moving back above $10,000, then the trading account witnessed a 10% drawdown.

Drawdowns are important for measuring the historical risk of different investments, comparing fund performance, or monitoring personal trading performance.

Drawdown

Key Takeaways

  • A drawdown refers to how much an investment or trading account is down from the peak before it recovers back to the peak.
  • Drawdowns are typically quoted as a percentage, but dollar terms may also be used if applicable for a specific trader.
  • Drawdowns are a measure of downside volatility.
  • The time it takes to recover a drawdown should also be considered when assessing drawdowns.
  • A drawdown and loss aren’t necessarily the same thing. Most traders view a drawdown as a peak-to-trough metic, while losses typically refer to the purchase price relative to the current or exit price.

The Drawdown Explained

A drawdown remains in effect as long as the price remains below the peak. In the example above, we don’t know the drawdown is only 10% until the account moves back above $10,000. Once the account moves back above $10,000 then the drawdown is recorded.

This method of recording drawdowns is useful because a trough can’t be measured until a new peak occurs. As long as the price or value remains below the old peak, a lower trough could occur which would increase the drawdown amount.

Drawdowns help determine an investment’s financial risk. The Sterling ratios use drawdowns to compare a security’s possible reward to its risk.

A drawdown is the negative half of standard deviation in relation to a stock’s price. A drawdown from a share price’s high to its low is considered its drawdown amount. If a stock drops from $100 to $50 and then rallies back to $100.01 or above, then the drawdown was $50 or 50% from the peak.

Stock Drawdowns

A stock’s total volatility is measured by its standard deviation, yet many investors, especially retirees who are withdrawing funds from pensions and retirement accounts, are mostly concerned about drawdowns. Volatile markets and large drawdowns can be problematic for retirees. Many look at the drawdown of their investments, from stocks to mutual funds, and consider their maximum drawdown (MDD) so they can potentially avoid those investments with the biggest historical drawdowns.

In many cases, a drastic drawdown, coupled with continued withdrawals in retirement can deplete retirement funds considerably.

Drawdown Risk

Drawdowns present a significant risk to investors when considering the uptick in share price needed to overcome a drawdown. For example, it may not seem like much if a stock loses 1%, as it only needs an increase of 1.01% to recover to its previous peak. However, a drawdown of 20% requires a 25% return to reach the old peak. A 50% drawdown, seen during the 2008 to 2009 Great Recession, requires a whopping 100% increase to recover the former peak.

Some investors choose to avoid drawdowns of greater than 20% before cutting their losses and turning the position into cash instead.

Drawdown Assessments

Typically, drawdown risk is mitigated by having a well-diversified portfolio and knowing the length of the recovery window. If a person is early in her career or has more than 10 years until retirement, the drawdown limit of 20% that most financial advisors advocate should be sufficient to shelter the portfolio for a recovery. However, retirees need to be especially careful about drawdown risks in their portfolios, since they may not have a lot of years for the portfolio to recover before they start withdrawing funds.

Diversifying a portfolio across stocks, bonds, precious metals, commodities, and cash instruments can offer some protection against a drawdown, as market conditions affect different asset classes in different ways.

Stock price drawdowns or market drawdowns should not be confused with a retirement drawdown, which refers to how retirees withdraw funds from their pension or retirement accounts.

Time to Recover a Drawdown

While the extent of drawdowns is a factor in determining risk, so is the time it takes to recover a drawdown. Not all investments act alike. Some recover quicker than others. A 10% drawdown in one hedge fund or trader’s account may take years to recover that loss. On the other hand, another hedge fund or trader may recover losses very quickly, pushing the account to peak value in a short period of time. Therefore, drawdowns should also be considered in the context of how long it has typically taken the investment or fund to recover the loss.

Example of a Drawdown

Assume a trader decides to buy Apple stock at $100. The price rises to $110 (peak) but then swiftly falls to $80 (trough) and then climbs back above $110.

Drawdowns measure peak to trough. The peak price for the stock was $110, and the trough was $80. The Drawdown is $30 / $110 = 27.3%.

This shows that a drawdown isn’t necessarily the same as a loss. The stocks drawdown was 27.3%, yet the trader would be showing an unrealized loss of 20% when the stock was at $80. This is because most traders view losses in terms of their purchase price ($100 in this case), and not the peak price the investment reached after entry.

Continuing with the example, the price then rallies to $120 (peak) and then falls back to $105 before rallying to $125.

The new peak is now $120 and the newest trough is $105. This is a $15 drawdown, or $15 / $120 = 12.5%.

The Meaning of Drawdown in Forex

Adam Gault / Getty Images

When it comes to forex trading, drawdown refers to the difference between a high point in the balance of your trading account and the next low point of your account’s balance. The difference in your balance reflects lost capital due to losing trades.

When you lose money on trades, you have what is known as a drawdown. As an example, say that your currency trading account begins with a balance of $100,000. You work your trading system, and after a bad trade, you see your account’s equity drop down to $95,000. Your account has experienced a $5,000 drawdown.

What You Can Learn From a Drawdown

Drawdowns also describe the likely survivability of your system over the long run. A large drawdown puts an investor in an untenable position.

Consider this: A client who endures a 50% drawdown has a large task and a real challenge ahead of him because he must have a 100% return on his reduced capital stake just to break even on the reduced equity position.

Many investors or fund managers on Wall Street are ecstatic with around 20% profit for the year. As you can imagine, when a trader suffers a drawdown, he’s best served by implementing good risk-management procedures and readjusting his system as opposed to trying to aggressively trade his way back to the breakeven point.

Typically, a trader’s aggressive approach to get his capital back to break even will have the opposite result. Why? He will most likely become emotional, using leverage and over-trading to get his trading account back to even.

Too Much Leverage

When traders use too much leverage, one bad trade can have disastrous effects—and it often does. In short, traders are either too aggressive or too confident, and this leads to large losses or an unwillingness to accept a trade that is a loser and should be cut. There is an old adage in trading that one trade will rarely make your trading career, but one bad trade can certainly end your career.

What I Learned Losing $1,000,000 by Jim Paul and Brian Moynihan offers some excellent insight if you’d like to read a book that describes the emotional toll of drawdowns.

The book discusses how, by taking a large drawdown, a trader lost his career, significant amounts of his family’s fortune, and money belonging to his friends.

The book also shares several tips on how to overcome common pitfalls of trading, such as implementing a trading plan that is likely to be emotionally driven instead of risk-management-driven.

The Takeaway

One of the most important and useful tips is to set a predetermined stop-loss point for your trade before entering. This will limit the amount of any drawdown you will take. Avoid making trading decisions based on emotion and, instead, focus on a strategy based on managing risk by exiting trades early enough to minimize your losses.

Once you take these steps, you’ll be able to stand back after you’ve entered a trade, knowing that you’re out of it with no questions asked when and if your stop-loss level is hit.

A lot of traders make the mistake of trying to negotiate with the market as to whether they should stay in a losing trade. This is a mistake because you’ll be making your trading decisions based on emotion instead of strategy, and you may do the thing that is the least painful at the time, but not necessarily more beneficial down the road.

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