What Is Drawdown and What Does It Mean?
- Ronald van Rensburg
- Aug 18, 2023
- 2 min read
Whether you are self-trading, investing in a hedge fund, or copy trading, you will run into drawdown. It is fairly easy to get drawdown wrong and to think it is something other than what it is. I, myself, always thought that it is only an indication of poor performance on an investor or a trader’s portfolio. But that was not it. This is why I decided to share with you what drawdown is and what it means.
How Is Drawdown Calculated?
Drawdown is the percentage difference between the first peak and trough after the entry of a position or trade. Let’s take an example: during a bullish trend, a trader opens a buy position at a price $100.
The drawdown is measured from the first peak encountered when a price drop is experienced, let’s say at $105, to the trough which is created during the continuation of the bullish trend, at a price of $95. It is measured until the price moves back above the entry point at $100.
In this case, the total drawdown would be $10. Keep in mind that drawdown is calculated until the price recovers past the initial entry point of the trade.
See Figure 1.
Figure 1
Drawdown is usually stated as a percentage in relation to the share price.
Drawdown % = (Trough Price – Peak Price) / Peak Price
Drawdown % = ($95 – $105) / $105
Drawdown % = -9.52%
What Does Drawdown Indicate?
Drawdown is an indication of the risk associated with the instrument in the market and is generally used in supplementary calculations to determine risk on the portfolio. The bigger the drawdown, the higher the risk associated with the instruments traded on the portfolio.
It can also be used to reduce risk by diversifying across multiple asset types and staying away from the assets with higher risk. Additionally, drawdown can be used to monitor the effectiveness of entry strategies that a trader uses and adjust as required.
In Conclusion
Drawdown can be used as an indication of the risk associated with the instrument or portfolio. So, if you are an investor that is not willing to take on risk in relation to reward, then stay away from portfolios associated with high drawdowns.
Additionally, as a trader, you can use drawdown as an indicator of when to potentially exit a specific trade because of a trend reversal as well as monitor the effectiveness of entry strategies.
If you are interested in understanding the valuation and risk of equity stocks please feel free to contact our analyst, Ronald van Rensburg, or open a stocks trading account here, so that you do not further miss out on opportunities to make profits that are prevalent in the current markets. Try Tradeview Markets.
About the author
Ronald van Rensburg
Analyst at Tradeview Markets
Email: rvrensburg@tvmarkets.com
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