What is a Drawdown in Trading?

You can’t avoid all risks in trading and investing. Markets are volatile, and your trading account or a particular asset may experience a drop in value at some point — it’s just part of the game. But so is managing risks.

That brings us to an important question: What is a drawdown in trading? Understanding drawdown is critical to long-term trading success.

How Does a Drawdown Work?

A drawdown is a decline in the value of a stock or account over a specified time before it returns to a new peak.

Typically, this occurs when a series of trades leaves an asset or account lower than its previous balance. The difference between that previous balance, the peak, and the low point it hit before reaching a new peak, the trough, is the drawdown.

While a drawdown shows how an asset or account loses value over a given period, it isn’t defined as a loss — another peak is necessary to create a trough and measure a drawdown. However, the value of your asset or account may or may not be less than your capital investment.

A drawdown can be an absolute monetary value, but it’s most commonly expressed as a percentage to help traders better see and evaluate the drop in the value of the asset or overall account.

You can find the drawdown of an asset or account in several ways, but the most straightforward method is to simply take the peak, subtract the trough, divide the difference by the peak, and multiply by 100. Here’s the formula:

Drawdown = ((Peak — Trough) / Peak) x 100

For a trader, drawdown is a reliable way to measure risk and potential loss. The higher the percentage of the drawdown, the higher the risk. In this way, drawdown can help you identify and manage potential risks.

Causes of Drawdowns

Several factors can lead to drawdowns. While a drawdown is inevitable, understanding the possible causes can help traders and investors mitigate their overall risk.

All of the following factors can lead to drawdowns:

• Market Fluctuations: Stocks can be volatile and are often subject to price fluctuations in response to economic news, political events or company announcements
• Political or Economic Events: World events such as elections, geopolitical unrest or economic news on inflation or interest rates can lead to lower values
• Company-Related Factors: Lower company earnings, changes in management or product recalls could lead to a company’s stock falling, causing a drawdown

Your individual trading and risk management strategies also have an impact on drawdowns.

Risk Management in Drawdowns

Calculating drawdowns can help you assess the risks in your trading strategies and the volatility of your returns. There are three main types of drawdowns: absolute drawdown, maximum drawdown and relative drawdown.

Absolute Drawdown

An absolute drawdown tells you about the drop in value from your initial investment. It’s a measure of the loss from your initial capital to the lowest trough, giving you an indication of the potential risk in your account.

Maximum Drawdown

The maximum drawdown is the difference between your asset or account's highest peak and the lowest trough. It’s measured over a long period, and it can indicate potential losses per trade or on a series of trades.

Relative Drawdown

Relative drawdown measures the difference from an asset’s trough to its previous peak. It’s expressed as a percentage. As a trader, relative drawdown can help you assess how well your trading strategies are performing and determine your ability to recover from losses.

Taking the time to understand which strategy or strategies can help you recover your losses is significant, as a percentage drop in your account isn’t typically matched by an equal percentage increase.

For example, if you invest $100 and gain 20%, you’ll have $120. If you witness a drawdown of 20%, your account drops to $96. To compensate for your loss, you need a gain of 25% ($24) to return to $120.

The key is to be patient and have a strategy in place to recover that loss over time. Do not veer from your plan in an attempt to make up the loss right away.

Impact of a Drawdown on Trading Performance

Drawdowns are inherent in trading so you can expect occasional dips in performance regardless of your trading strategies. However, large drawdowns can be a sign of trouble. Big drawdowns could indicate something wrong with your trading strategy or lack of sound risk management. 

Properly managing drawdowns can go a long way toward preserving your capital investment. You can employ several strategies to keep drawdowns small and manageable or mitigate their impact on your trading account (and your psychological well-being).

Consider using these tried-and-true strategies to manage drawdowns:

• Use Stop-Loss Orders: Place tactical orders to buy or sell at a set price.
• Diversify: Mix up your assets and trading strategies across markets.
• Develop a Trading Plan: Your trading plan is your road map for trading success, so stick to it.
• Learn and Adjust: Review your trades and learn as much as possible from them to avoid surprises.

Drawdowns can cause some investors and traders to panic, which is understandable. After all, watching your capital or gains melt away can be alarming. However, becoming familiar with drawdowns and knowing how to deal with them can help you keep cool and not make trading or investing decisions based on emotion.

By evaluating your drawdowns, you can choose the appropriate trading strategies and risk management tactics to begin recouping your losses.

Real-Life Examples of a Drawdown in Trading

The following example will illustrate how a drawdown could impact your capital, trading strategy and general sensibilities:

Say you deposit $100,000 into an account and lose $25,000 through a series of trades. That leaves you with a drawdown of 25%. Compounding the loss, you realize you’ll need nearly a 34% gain on the remaining $75,000 to get back to your initial investment.

This may seem like a bad situation, but as long as you remain calm, stick to your trading plan and focus on the long term, your asset or account will likely recover.

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Evaluate Your Risk Factors Alongside Your Potential Returns

Due to the fundamental nature of markets, you can expect to experience drawdowns in your trading and investing from time to time. Try not to sweat it. Now that you no longer have to ask, “What is a drawdown in trading?” you can stay focused and make intelligent decisions to keep yourself in the black.

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