What Is a Drawdown?

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 metric, 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 the 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.

Drawdowns are of particular concern to those in retirement. 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.

The uptick in share price needed to overcome a particularly large drawdown can become significant enough that some investors end up just getting out of the position altogether and putting the money into cash holdings 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 stock’s 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%.

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What is forex trading and how is it done?

Automated trading vs manual trading

In this post, we explore what is forex trading, how to start forex trading, how to trade forex and how does forex trading work. The differences between automated trading vs manual trading. While manual trading has been around much longer, automated trading is now more readily available to retail traders which has only intensified the debate on which style is best. Let’s dig a little deeper into both!

What is manual trading?

What is manual forex trading, how to start manual forex trading, how manually to trade forex and how does forex manually trading work. Manual trading is where a trader will make a decision on when to buy or sell an asset and then place the trade themselves via market or pending orders. The manual trader may also scan multiple markets first to actually find an opportunity before deciding to act. In essence, most of the work is done by the trader which means their output is only as good as their input.

For example, an intraday Forex trader may spend the morning scanning through a list of different currency pairs to find combinations of technical trading events using indicators and other types of analysis. They may then either place a buy or sell order themselves or build a watchlist and set alerts to notify them when an asset’s price has reached a price level they would consider buying or selling at.

The trader may then make the decision to buy or sell by placing the order themselves. Some traders may also opt to manage trades themselves by moving stop loss and take profit levels as the market moves with them. In manual trading, it is the trader which has to make all the decisions and act.

What is automated trading?

What is automated forex trading, how to start automated forex trading, how to automatically trade forex and how does forex automated trading work. Automated trading is where a pre-programmed algorithm will make all the decisions on what to buy and sell, and when, based on the instructions written in its code. A trader, programmer or ‘quant’ may code their manual strategy so when certain rules or events occur, the algorithm will automatically take trades.

For example, an intraday Forex trader may hire a programmer to convert their manual trading strategy into an automated trading strategy. After some testing, they may realise the conditions are too loose or too constrictive. After a period of optimisation, the trader may be satisfied with their algorithm and then go and test it using a demo trading account. Even when they go live, the trader may test it on a small account first before allocating more capital.

It is a marked difference to those who believe their manual trading rules will work in an automated trading system. Successful automated traders consistently test, optimise and develop their systems slowly. In this situation, the trader doesn’t need to be there to find the trade or execute the trade. They can spend more time optimising their trading systems and building more.

And what is the best automated trading software available? Well, one of the most popular platforms for auto trading and manual trading is MetaTrader. You can download it for FREE today and explore all of its features to trade on multiple asset classes!

Automated trading vs manual trading

When it comes to deciding which style of trading is actually best, there are various factors at play such as experience, time, resources available and more. Below is a list of the pros cons for each type of trading style:

Auto trader pros

Completely removes emotion from trading decisions. Most new traders simply struggle to keep on trading a strategy when they have had a few losing trades thereby never achieving a consistent set of trades to allow a statistical edge to work in their favour. Auto trading removes this emotion as the trading robot can execute your trades without any emotion.

In this style of trading, traders can build a portfolio of different systems to cover different market conditions allowing for a level of diversification in their approach. As the algorithm can also show all the previous historical trades, traders can quickly identify whether a system has worked historically and gain useful statistics to understand when it will stop working in the future (such as exceeding historical consecutive losses, etc).

New traders can start out with a demo account to test different strategies available for free or purchase one from the MetaTrader Market place. This is a useful way to see if auto trading is actually right for them.

Auto trader cons

The past does not guarantee the future. Just because a system has worked historically, it does not mean that it will work in the future. Market conditions change, volatility changes, trends change, etc.

It is very easy for auto traders to over-optimize their system and change criteria to make their historical results look fantastic. Known as ‘curve fitting’ among auto traders, it is a very common issue. While traders may find the best variables for their system on historical data, it doesn’t mean anything on future price data.

There is a cost to hiring a programmer to help code a trading strategy. Any optimisations or changes may also require more cost to investigate and amend. The other option is for traders to learn how to code themselves which for most would be another con.

Manual trader pros

Through manual trading, the trader has to learn about the market they are trading, the tools they are using and methods of making trading decisions such as technical analysis and fundamental analysis. This is a great way to build knowledge about trading which can then be useful when trying to devise an automated trading system.

In manual trading, traders have a bit more control on what to do when. From a mindset perspective, this is powerful. Especially if a trader is trading on live money. Knowing that you have a trade on, inputting the details and seeing the stop loss on the chart yourself can help to feel more settled in managing an account.

With manual trading, a trader can actually identify what is working for them and what is not working for them. Typically, most traders struggle with the mindset aspect of trading and even more specifically, taking losing trades which is an inevitable part of the business. But by understanding what is not working, they can work on it to become better.

Manual trader cons

Manual trading does take time. The trader needs to perform research, be there to place their orders and spend time reviewing their trades and individual behaviour to try and reach superior performance. Some of these tasks can be semi-automated though. For example, a trader could use pending orders to instruct their broker to close trades at profit or loss at certain predetermined price levels.

A disciplined mindset is required to trade successfully. Many traders often let their emotions get to them and start to ‘gamble.’ It is up to the trader to maintain discipline in risk management at all times, making sure they don’t risk too much to allow for losing trades, making sure they actually trade consistently to allow a statistical edge to work in their favour and making sure they focus on their processes rather than all the noise of other people’s opinions.

Many manual traders struggle with being solely accountable for their trading account and will often blame their strategy, or their platform, or their broker, rather than look internally at their own behaviour and decision-making abilities.

Fortunately, manual traders can access automated trading services to help identify potential trading opportunities! With Your broker you can upgrade and supercharge your MetaTrader trading platform with the Supreme Edition plugin.

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