What is Drawdown in Trading?

Key Highlights

Risk management is very important in trading or investing activities. And proper risk management is what keeps you in the game. When developing an investment strategy, a trader will need to create one that provides them with an edge in the financial markets. 

In a nutshell:

• Drawdowns can be expressed in absolute monetary terms or as a percentage
• Drawdowns help measure how much an investment account has gone down from its peak point before it begins its recovery journey.
• A drawdown risk refers to the percentage that the investment account will need to gain for it to overcome its losses or the impact caused by the drawdown. 

What is Drawdown in Trading?

If you trade or invest for long enough, you’ll notice that there will be periods when the portfolio will go down before it rises again. Such declines are a normal part of the market cycles, and what many traders fail to realize is that how deep they go matters a lot. 

And this is where the drawdown concept becomes important.

Understanding what a drawdown is and how it works can help you manage risk, set expectations, and avoid revenge trading when the market conditions take a downward turn. It will also provide you with a clearer picture of how the trading strategy behaves when things aren’t going as planned.

Read on to learn what a drawdown is in trading!

What Is Drawdown?

A drawdown is the percentage decline from an investment portfolio’s peak value to its lowest point before it begins to recover and attain a new high. 

If I were to define it using simple terms, I’d say a drawdown shows how much your portfolio has lost during a downturn, and not just the percentage gained during moments when the market conditions are good.

Let’s use an example:

If the portfolio grows from say $10,000 to $12,000, and then goes on a reversal that sees it fall to $9,000 before rising again, the drawdown will be measured from its highest peak, which is $12,000, to its low of $9,000.

The drawdown in this case will, therefore, be 25%. 

Put simply:

The portfolio’s peak will be its highest balance

The trough refers to the lowest balance attained after that peak

The drawdown is thus a measure of the drop between these two points

How Does Drawdown Work?

Drawdown in trading is normally expressed as a percentage, and not as a dollar figure. Representing it this way makes it simpler to compare risk across different strategies or portfolios. 

1. Identify the Peak: The peak refers to the highest value attained by a portfolio before beginning a decline. 
2. Establish the Lowest Point: This refers to the lowest value attained by the portfolio before it starts its recovery journey.
3. Calculate the Percentage Drop: A drawdown is calculated as the decline from the highest to the lowest point, divided by the peak value. The drawdown will continue until the portfolio has recovered fully and attained a new high. Before this happens, the portfolio will still be considered as being under a drawdown period. 

Types of Drawdown

Learning about the different types of drawdown will be important for evaluating your trading risk and for managing expectations in the financial markets. 

1.Maximum Drawdown (Max DD)

A maximum drawdown is defined as the worst dip any investment can take from its highest to lowest point. In trading, the maximum drawdown helps indicate the downside risk over a given duration and shows potential stock volatility. 

Deeper Insights into Maximum Drawdown

A maximum drawdown refers to a specific measure of drawdown that seeks to establish the greatest movement from a peak point to a low point, before an investment attains a new peak. Please note that the maximum drawdown only measures the largest loss size, and not the frequency of the losses.

It’s also worth noting that the maximum drawdown doesn’t indicate how long it takes for the portfolio to recover from its largest loss or whether recovery even happens. For traders, maximum drawdown helps in comparing the riskiness of stock screening strategies.

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For example, it’s possible for two screening strategies to have the same tracking errors, average outperformance, and volatility, but then turn out to have different maximum drawdowns when compared to the benchmark. 

A low maximum drawdown is often preferred as it indicates small investment losses. When you have an investment that’s not losing money, it means that the portfolio has a maximum drawdown of zero. 

Real World Example of a Maximum Drawdown 

Let’s use an example to help you better understand the concept of a maximum drawdown in trading. Assume you have an investment portfolio that has a starting value of $500,000. During trading, its value rises to $750,000, and then dips to a low of $400,000.

After a while, the portfolio goes on a rebound and attains a new height of $600,000 before going on a bear run that sees it dip to $350,000. The portfolio subsequently doubles to $800,000 after trading for a period of time. Now, the question is, ‘What’s the maximum drawdown?’

2.Daily Drawdown

The daily drawdown refers to the maximum amount that your funded trading account is permitted to lose on any given day. Prop firms recalculate this limit daily based on the balance available in the account at the beginning of the trading day. This means that the clock will reset every 24 hours.

Please note that it would be game over for you if your balance were to drop below the allowed limit during the course of your trading activities. But while this may be the case, there’s no need to panic. Once you get a good understanding of how daily drawdown works, you’ll find that it can become more of an asset than an obstacle.

Calculating the Daily Drawdown Limit

Let’s say that you’re trading with a funded account having a $200,000 ceiling and an accompanying daily drawdown limit of 4%. In such a setup, it will mean that your daily drawdown limit is $8,000.

With such a limit, it means that if the balance available in the account were to dip below $192,000, the account will be said to have violated the firm’s rules. 

On the other hand, if you make a profit and the balance increases to $210,000, the new daily drawdown limit will be calculated as follows: $8,400 (4% of $210,000).

Why the Daily Drawdown Limit Matters

The daily drawdown matters because:

• It helps the trader stay disciplined: It’s a rule that prevents emotional trading on days when the market conditions are unfavorable, encouraging you to stick to your trading strategy. 
• It Builds Professional Habits: Understanding how the drawdown works will help you prepare for Live trading, where risk management makes all the difference. 

3.Relative Drawdown

Relative drawdown provides important insights into the losses made by an investment portfolio in relation to its highest point, thus helping to distinguish it from the initial investment perspective of absolute drawdown. 

Your ability to reduce relative drawdown is, in most cases, a measure by which the funded trading account is assessed and managed. This strict criterion underscores the need for you to be well-versed in how a drawdown can impact your account’s sustainability. 

So, what makes relative drawdown such an important approach?

1. It plays an important role in the psychological aspect of trading and signifies periods where strategy fortitude and risk tolerance are critically tested. 
2. The relative drawdown limit quantifies the impact of a downturn and affords you a benchmark for trading risk exposure. 
3. It offers a comparative metric that provides much-needed clarity on trading efficacy during peak-valued market cycles. 

Calculating the Relative Drawdown

A relative drawdown is an important metric in evaluating investment strategy health and pinpointing losses, as it assists in capturing the drop in the value of your portfolio. Accurately measuring such downturns will enable you to properly calculate trading risk and adapt your approach for enhanced performance when trading. 

To calculate the relative drawdown, you’ll need to:

1. Identify the peak equity value of your funded account 
2. Record the lowest equity point after the peak identified above
3. Subtract this lowest value from its high point to establish the absolute drawdown amount
4. Divide the absolute drawdown amount arrived at above by the high point to find the relative drawdown percentage. 

Let’s use an example to help you understand how this works:

Account Peak Value: $60,000

Trough Value After Decline: $55,000

Absolute Drawdown: $5,000

Relative Drawdown: 8.33%

4.Absolute Drawdown

Absolute Drawdown is normally used to adjust position sizing and calculate stop loss levels. The absolute drawdown values refer to the total amount of capital that a funded account can lose. Often, this figure is shown as a monetary amount.

To calculate the absolute drawdown, you’ll need to subtract the trough (the lowest point of equity) from the peak amounts recorded over a certain duration. Monitoring the absolute drawdown over time can help you evaluate the stability and overall performance of your trading strategy. 

You can then use this figure to optimize your future trading decisions. 

Here’s an example of an absolute drawdown {Link down to Absolute Drawdown}: 

Opening Balance: $100,000

Lowest Equity: $95,000

Absolute Drawdown: $5,000 ($100,000 - $95,000)

5.Fixed Drawdown

A fixed drawdown limit in prop trading is a type of drawdown where the minimum balance for the funded account remains at a fixed rate. It’s a drawdown that’s exclusively applied to traders who have managed to pass the evaluation phase. 

Once the fixed drawdown limit has been applied, your account isn’t allowed to drop below the specified minimum balance. Failure to abide by this rule will lead to account closure and your subsequent departure from this funded program. 

As such, if you’re to succeed, you’ll have no option but to adapt your trading strategy to this drawdown model. For you, the implication will be as follows:

• You now have the freedom to participate in swing trading
• You’re now in a better position to hold trade positions for extended durations
• You can now build a profit cushion before increasing your position sizes 

6. Trailing Drawdown

Prop trading firms use the trailing drawdown to limit the maximum amount that you can afford to lose as the account continues to grow. 

Look at it this way:

When starting the evaluation challenge, the account will have an opening balance of $10,000 and a trailing drawdown of 10%. In this scenario, it means that the total amount you can lose when trading is $1,000. 

If you were to make a profit of $500 on the initial balance, it would mean that the account would now have a balance of $10,500. Your drawdown limit will also adjust to match this new balance. The drawdown limit will now sit at $9,500.

What this means for you is that if the balance ever drops below the $9,500 mark, you’ll be seen to have failed the challenge. It’s important to note that as the account balance increases, so will the limit, and once it has gone up, it won’t come down. 

The drawdown limit helps in protecting the firm’s capital and will push you to grow your account steadily without reckless drawdowns. Common types of trailing drawdowns include:

• End-of-Day Trailing Drawdown: As the name suggests, this type of drawdown will only update at the end of the closing day and will typically be based on the profits made from the closed positions.
• Intraday Trailing Drawdown: It’s a type of drawdown that will update in real-time. Please note that this type of drawdown uses live equity and will thus include even the unrealized profits. 

A trailing drawdown matters because it punishes poor risk management, emotional swings, and overleveraging, therefore forcing you to trade with discipline. Prop trading firms are known to use the trailing drawdown to help weed out gamblers. 

Learn more about Trailing Max Drawdown

7.Equity Drawdown

An equity drawdown is a decline or drop in your equity value from the account’s daily peak value. It can help you to become a more responsible and strategic trader.

Equity refers to the value of your funded account and includes the balance in the account and any potential losses or unrealized profits on your open trade positions.

You should note that the equity tends to change depending on the performance of your open positions. 

How an Equity Drawdown Works

An equity drawdown differs from a balance-based drawdown in that, instead of considering money won or lost from your closed trades, the equity drawdown is a real-time metric: a metric that will change as the price fluctuates. 

Prop firms use the equity drawdown to ensure that their traders use the right risk management approach. To calculate the equity-based drawdown, follow the steps below:

1. Start by determining the starting day's equity
2. The next step is to identify the current equity value
3. Establish the difference between the daily starting equity and the current equity
4. Express the result achieved above in the form of a percentage

8.Balance Drawdown

A balance drawdown refers to the dollar amount or percentage decline in a funded trading account from its highest attained point to its lowest point before it attains a new high. 

In a balance-based maximum drawdown, the value is calculated as the percentage of the opening account balance. The resulting value will remain fixed no matter the number of profits made. 

How the Balance-Based Drawdown Works

Given that the balance-maximum drawdown is based on your starting balance, it will set a constant threshold below which the funded account’s equity/balance shouldn’t fall. If you breach this level for any reason, the prop firm will see it as a breach of its rules and terminate your trading account.

Let’s look at an example:

Initial Account Balance: $100,000

Maximum Drawdown Percentage: 8%

In our example above, the funded account equity/balance must remain above the $92,000 mark to avoid breaching the company’s rules. 

Here’s a trading scenario:

• You have a funded account with a balance of $100,000
• After trading for a few days, you get to grow the account’s balance to an impressive $120,000
• Even with the new balance that has been realized after making a profit, the Maximum drawdown will remain at the 8% threshold. 

What this means for you is that you have to make sure the balance doesn’t dip below $92,000 or else the account will be closed.

How Traders and Investors Manage Drawdowns 

While it’s impossible to avoid drawdowns completely, this doesn’t mean that they can’t be managed. Some of the commonly used approaches include:

• Using stop losses when engaged in active trading
• Proper position sizing to limit the losses made per trade
• Diversification across various sectors and assets
• Matching strategy risk to your particular time horizon
• Maintaining realistic expectations about market conditions and cycles 

Long-term traders can often accept a moderate drawdown in return for growth. If you’re an active trader, you should aim to lower your drawdowns to remain flexible and safeguard capital. 

Conclusion

A drawdown helps in measuring how much your investment portfolio has fallen from its peak point before beginning its recovery. It’s among the easiest and clearest ways to understand trading risk, especially when the market goes on a bear run. 

By paying attention to the different types of drawdowns mentioned in this guide, you can employ trade strategies that avoid unnecessary stress, fit your risk tolerance, and stay invested through ordinary market fluctuations. 

If you’d like to start building your trading experience while effectively managing your risk, you can explore different markets through the Audacity Capital trading platform. And remember, fractional shares will make it easy for you to learn and scale your account. 

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