What Does Drawdown Mean In Trading?

What Does Drawdown Mean In Trading?

Asset prices on financial markets move up and down all the time. When prices reach peaks over a certain time, they are likely to fall down to a trough.

These rises and falls are evident on a price chart. Many traders look at the difference between the peak and trough price points to evaluate the average price movements of a particular asset. 

The difference between the peak and trough prices is called the ‘drawdown’. 

Drawdown is a common term used by traders and analysts as a measure of risk and can help them assess the potential downside in their portfolios.

It is often expressed as a percentage and is used to evaluate the historical performance and risk associated with a trading strategy or investment.

When an instrument has a high drawdown, traders may find more profitable opportunities. 

If you are a beginner trader and would like to know more about what drawdown means in trading, this Investfox guide is for you. 

How Drawdown Works In Trading

In trading, "drawdown" refers to the peak-to-trough decline in the value of an investment or trading account before it begins to recover.

It quantifies the extent of losses experienced from a previous high point.

For example, if a trader's account reaches a peak value of $10,000 and then experiences a series of losses, bringing the account's value down to $7,000, the drawdown would be $3,000 (the difference between the peak and the lowest point).

If expressed as a percentage, the drawdown would be 30% ($3,000 divided by the initial $10,000).

A higher drawdown percentage indicates a greater risk of significant losses in the trading strategy or investment. However, this also means that the instrument presents more short-term trading opportunities for traders with a higher risk appetite. 

Drawdown Example

When describing drawdowns on a price chart, it is important to consider the individual components that make up a drawdown pattern, such as:

  • Peak Value: Drawdown is calculated by measuring the percentage decline in the value of a trading account or investment from its highest point, or peak, to the lowest point reached during a specific time frame
  • Trough Value: The trough value is the lowest point that the trading account or investment reaches during the specified time frame. It represents the account's lowest balance or the lowest market value of the investment during that period
  • Drawdown Percentage: To calculate drawdown, you subtract the trough value from the peak value and then divide that result by the peak value. The formula for drawdown percentage is as follows:

Drawdown (%) = [!peak!] × 100

  • Monitoring and Management: Traders and investors use drawdown to assess the risk and volatility associated with a particular trading strategy or investment. It helps them understand how much they could potentially lose during a losing streak
  • Recovery: After experiencing a drawdown, traders and investors aim to recover from the loss and return to profitable territory. This may involve adjusting their trading strategy, reducing position sizes, or waiting for better market conditions
  • Risk Tolerance: Drawdown is closely related to an individual's or institution's risk tolerance. A trader or investor with a lower risk tolerance may find a high drawdown unacceptable and may prefer conservative strategies, while a trader with a higher risk tolerance might be willing to tolerate larger drawdowns in pursuit of potentially higher returns

Drawdown Example In Trading

To better illustrate how drawdown works in trading, let’s look at an example of a stock with a high drawdown over a 1-month period of trading. 

For example, AMC has a substantial drawdown, which presents highly profitable opportunities for traders, but can also lead to substantial losses:

amc drawdown.png

As we can see, due to the high volatility of AMC stock, the maximum drawdown for the investment over a 1-month period is substantial. While traders could have lost a lot of their funds with AMC, this also means that the stock shows a lot of opportunities for options traders and speculation in general. 

As a rule of thumb, instruments that are characterized by high volatility tend to have higher absolute drawdowns, which makes them risky, but also lucrative for short-term speculation for traders. 

Key Takeaways From What Does Drawdown Mean In Trading

  • In trading, drawdown refers to the difference between the peak and trough values of an instrument on a price chart 
  • Volatile instruments tend to have higher drawdown percentages, which means that they are risky investments that could result in substantial losses
  • The formula for calculating drawdown is: Drawdown (%) = [!peak!] × 100
  • Stocks with a high drawdown are better for short-term speculation, while those with a low drawdown are viewed as more secure long-term investments

FAQ On Drawdown In Trading

Is a high drawdown good in trading?

No, a high drawdown is not good in trading. It indicates significant losses relative to the initial capital, which can be risky and challenging to recover from. Traders typically aim to minimize drawdowns to preserve their capital and achieve long-term success.

What happens when a stock has a low drawdown?

A stock with a low drawdown experiences relatively small price fluctuations and limited losses compared to its peak value. This can be a positive sign for investors, as it suggests lower risk and potentially more stable returns over time.

How is drawdown calculated?

Drawdown is calculated by measuring the percentage decline from a trading account's highest peak value to the lowest subsequent point before a new high is reached. It helps assess the risk and potential losses in trading or investment.