What is Drawdown Trading?

If you follow your investments closely, you know the elation that comes when an investment rises. But you also know the feeling of disappointment when that same investment plunges.

However, these plunges are good for more than just causing undue emotional stress. When you measure a drawdown — defined as the measure between an investment’s peak and lowest trough — you can conquer investment challenges with drawdown trading.

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How Does Drawdown Trading Work?

In trading, drawdown refers to the difference between an investment’s peak and the trough that follows. However, there’s a catch. The drawdown is not officially recorded until the account or investment reaches or surpasses its previous peak. Why? Until the investment returns to where it was, an even lower drawdown is still possible.

When it comes to trading, drawdowns are valuable tools for predicting a stock’s level of risk. Before investing, you can view an investment’s historical drawdowns. This measure will give you a better picture of the investment’s risks vs. its benefits.

If you find that your own investments have been severely impacted by drawdowns, you also have the opportunity to adjust your trading strategy and adopt better risk management practices. Over time, actions like this will make you a better trader.

How to Calculate a Drawdown

You can more than likely find drawdown calculators online. But when you have a basic knowledge of the formula used, you’ll have a better sense of how they work. The formula itself is simple:

Drawdown (as a percentage) = (Total drop in price ÷ Peak) x 100

It’s easier to understand the calculation in practice. Let’s say you purchase a stock for $120. The price of that stock rises to $140 and then falls to $70 before rising back up above $140. In this example, your peak is $140 and your trough is $70, so the total drop in price was $140 - $70, or $70. 

Now that you have these values, you can use the formula above: (70 ÷ 140) x 100 = 50%, so your drawdown is 50%.

Example of Using Drawdown

Now you know how to calculate a drawdown. But how can this number help you? When you can quantify the drawdown of each of your investments, you can track and predict risk. In this sense, drawdowns can help you become a more successful investor.

Let’s look at an example of how to use drawdowns in trading. One technique is to set up a stop-loss order (through your trading account) on a volatile investment. With this type of order, you can set the maximum drawdown percentage you’re willing to tolerate.

Once you’ve set that stop-loss order, you don’t have to dedicate your time and attention to daily monitoring of your accounts. If the chosen account’s drawdown exceeds your limit, the platform you’re using will trigger a sale, protecting you from future losses.

So should you set a stop-loss order on every account? Probably not. While it’s true that it’s a great risk management strategy, it has the potential to set off an unnecessary sale. For instance, if one of your investments has a short-term dip that exceeds your threshold, the system may end up selling an investment you otherwise would have held.

Types of Drawdowns

There are two main types of drawdown: closed (also called a close-to-close drawdown) and open (also called an intraday drawdown). The difference comes down to how they’re measured:

• Closed drawdowns: Measured from one closing price to the next closing price
• Open drawdowns: Any drawdowns that happen during the day between two closings

By constantly paying attention to the drawdowns of your investments, you can understand potential volatility and better predict market risk and an investment’s performance over time.

What is the Impact of Drawdown in Forex Trading?

Ask any trader what they think of drawdowns in forex trading, and they’ll probably tell you that drawdowns are a bad thing. It’s true that unmitigated drawdowns can lead to significant losses. But drawdowns are also valuable teachers — they show you where you can strengthen your risk management strategy to lessen future losses.

If you’re in the middle of a drawdown right now, you need to consider the risks and benefits of waiting it out vs. cutting your losses and closing the trade. Larger drawdowns require a significant uptick to reach their former peaks, often making it difficult or impossible to recoup your losses.

How do you know when to sell and when to ride out the drawdown? That depends on your investments, but most financial advisers recommend letting your drawdowns get no greater than 20%. At 20%, investments have a good chance of recovering, especially if you don’t need to withdraw your funds for another 10 years or so.

On the other hand, if you’re a retiree or close to retirement age, some advisors suggest not letting your drawdowns exceed 10%. In this situation, you have far fewer years for your investment to recover.

There’s another sometimes-overlooked effect of drawdowns — they also profoundly impact trading psychology. When faced with a significant drawdown, some people become emotional and make rash trading decisions in an attempt to recover their losses.

Tips for Effective Drawdown Trading

No one looks forward to a drawdown. But if you’re a thoughtful investor who’s willing to grow, you’ll find that they can teach you valuable lessons that help you strengthen your trading strategy. Here are some tips to handle forex drawdowns:

• Use a stop-loss feature: With your forex signal provider, you can set a point (for example, a 20% drawdown) where trading will stop and your remaining balance will be protected.
• Lessen your risk with smaller trades: Smaller trades may not be exciting, but they reduce your risks of major losses.
• Adjust position sizing: By limiting the amount of capital you put in an investment, you can reduce your risk of continuing losses.
• Incorporate leverage control: When you limit your leverage (money you essentially borrow to trade), you also limit potential losses.
• Focus on your long-term plan: Keep drawdowns in context; if your overall strategy is profitable, drawdowns don’t matter as much.
• Avoid revenge trading: Some investors begin irrationally and aggressively trading to try to recoup their losses — don’t do that!

Of course, it doesn’t hurt to have expert guidance when you’re navigating trading in a drawdown. A financial adviser or a friend familiar with finance can help you sharpen your drawdown trading strategy.

You Can Use Drawdowns to Your Advantage

You can’t avoid drawdowns in forex trading, but that doesn’t make them any less stressful. However, when you understand how drawdowns work, you can use them to your advantage — whether that means protecting your capital with stop-loss orders, adjusting position sizing, developing a clearer risk management strategy or all three.

If you’re just embarking on your trading journey, you may benefit from the help of a qualified financial adviser. Benzinga offers a wealth of free resources to help make your trading experience a good one.

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