What is Drawdown? An Explanation…

What is Drawdown

Drawdown is the difference between the balance of your account and the net balance of your account. A drawdown is defined as the peak-to-trough decline during a specified recorded period of an investment, fund or commodity. It is typically represented as the percentage between the peak and the subsequent trough.

In reference to trading, “drawdown” refers to a drop in equity in a trader’s account. Let’s say you have a Rs.1,00,000 and you lose Rs. 50,000. What percentage of your account have you lost?

The answer is 50%.

Simple enough. This is exactly what traders call a drawdown.

A drawdown is the reduction of one’s capital after a series of losing trades. This is generally calculated as the difference between a relative peak in capital minus a relative trough.

What You Can Learn From a Drawdown

Drawdown assists you to measure the financial risk of the portfolio. It is an important measure of a portfolio or trading strategy and is much better than the traditional measures. Usually, a trader measures his portfolio returns or trading performance by measuring the return based on a specific time frame. For example, he would evaluate his return from the start of the month or start of the year.

Drawdown analysis is considered to be the most crucial analysis for any trader. During volatile markets, and markets that have a possibility of a correction, the drawdown is a serious concern for retirees. Drawdown helps measure the financial risk of the portfolio. It is an important measure of a portfolio or trading strategy and is much better than the traditional measures.

Normally, an investor measures his portfolio returns or trading performance by measuring the return based on a specific time frame. For example, he would measure his return from the start of the month or start of the year.

However, drawdown measures the performance from the recent high. Let’s consider an example to understand the importance of drawdown. If a portfolio of Rs 5 lakh touches a high of Rs 9 lakh his return would be 40 percent in the traditional way. Now if there is a correction in the market and his portfolio value falls to assume Rs 6 lakh his return in a conventional way will be 10 percent (initial investment was Rs 5 lakh and present is Rs 6 lakh). The trader would still be pleased since he has generated a confident return of 10 percent as has not lost his capital in spite of the severe fall.

However, in the drawdown method of computing returns, the portfolio has fallen by 33.3 percent from its peak. The drawdown would be calculated from the high point of Rs 9 lakh to the low point of Rs 6 lakh – a drop of 33.3 percent.

One of the greatest tips is to have a predetermined stop-loss point on your trade before entering. This will limit the amount of any drawdown you will take. Also, back testing of trading strategies helps to impart an idea of the maximum drawdowns that have occurred in the portfolio.

We at InvestarIndia have always worked towards designing Investar to be a one-stop solution for all traders. Towards this end, we are happy to say that our users can look forward to backtesting as a feature that will be coming in the near future to Investar to supplement our recently launched Custom Screener Beta.

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