Drawdown levels

Introduction to drawdowns

A drawdown level is the largest potential decrease in value that an investment or account could experience within a set time frame. It can also signify a decrease in the overall value of a trading portfolio or account. This reduction in trading capital carries a risk for traders, potentially leading to stop outs. Success in online trading often involves recognising and managing drawdown risk while pursuing potential rewards.

Managing losses in each trade or within a trading period is crucial for creating growth and a successful trading plan. Market volatility causes fluctuations in capital, but it also offers opportunities for profit - and profitability in trading occurs when gains exceed losses, leading to account growth.

Understanding drawdown helps traders assess market resilience during downturns. While capital fluctuations are normal, traders need to anticipate and handle shifts from peaks to dips effectively. Anticipating these downturns and making sure your strategy is prepared to handle them can be achieved by understanding drawdowns in detail.

Different types of drawdowns

Drawdown is the decrease from a peak to a trough in capital value. The peak and trough values used will depend on the type of drawdown a trader is analysing, such as absolute drawdown, maximum drawdown or relative drawdown.

Absolute drawdown: Often used to calculate stop-loss levels or adjust position-sizing, absolute drawdown values refer to the maximum amount of capital that could be lost in a worst-case scenario. It's shown as a monetary amount and is calculated by subtracting the lowest point of equity (trough) from the highest point (peak) within a specified period. Monitoring this over time will also help evaluate the overall performance and stability of your trading strategy, which can help optimise future decisions too.

Maximum drawdown: Unlike absolute drawdown which is shown as a monetary value, maximum drawdown measures in terms of percentage loss relative to the peak equity. This percentage is calculated by dividing the absolute drawdown by the peak equity value within a time period. It can also be used to set risk-management parameters and allocate capital accordingly to mitigate overall losses by preparing for drawdown periods in advance.

Relative drawdown: Relative drawdown is like measuring how much your wallet shrank during your worst shopping spree. It's the percentage decrease in your money from the highest point to the lowest, compared to your wallet's peak fullness. So, if your wallet was $100 at its fullest and dipped to $80, your relative drawdown would be 20%, showing how much you lost relative to your wallet's fullest state. In trading, this is percentage is calculated by dividing the difference between the equity at the trough and the equity at the peak, by the equity peak.

How to calculate a drawdown?

Absolute drawdown is an important consideration when setting risk parameters before you open a trade. Big losses at the beginning require more effort, such as big wins or a higher win rate, to break even. A loss of $1,000 from initial deposit of $10,000 is a 10% absolute drawdown, while a $5,000 loss out of initial deposit of $10,000 is 50% absolute drawdown. Recovering $5,000 will need higher win rate and risk-reward ratio compared to recovering the loss of $1,000.

Assuming the $10,000 initial deposit had grown to $13,000, and then suffered losses to $8,000, the maximum drawdown would be $13,000 - $8,000 = $5,000. The loss figure can exaggerate the situation, leading to efforts to recover higher amount of $5,000 rather than the absolute $10,000 (initial capital) - $8,000 = $2,000.

The relative drawdown can be applied to assess the severity of the loss, but recovery can be based on absolute drawdown to avoid unnecessary stress. When the loss is perceived to be bigger than it is, it can be discouraging and stir unwanted emotions in trading.

Risk control measures based on identified drawdown levels

Once drawdown figures are identified, it becomes easier to use specific risk control measures. In the event of a big drawdown, risk allocation of every position should be evaluated.

Depending on the number of trades taken in a specific trading period, drawdown limits need to be adjusted according to this number. For example, if a trader takes 2 positions in a day with a maximum drawdown limit of 2% per day, each position must be capped at 1% risk.

Let’s look at an example of this scenario.

Maximum daily drawdown limit allowed is 2%

Risk allocation per position:

• Since the trader has a maximum drawdown limit of 2% for the day and has taken 2 positions, the risk per position needs to be calculated.
• Risk per position = Maximum daily drawdown limit / Number of positions
• Risk per position = 2% / 2 = 1%

Application:

• If the trader's total trading capital for the day is $10,000, the risk per position would be 1% of this amount, which is $100.
• This means that for each of the 2 positions taken, the maximum acceptable loss would be $100.

A smaller risk takes less effort to recover potential losses without unnecessary exposure. The period for calculation of the drawdown levels is flexible depending on the trading style of a trader. Swing traders have the choice to base their drawdown levels on weekly periods. The same applies to investors that can use month-on-month drawdown calculations.

Assigning the drawdown amount for a specific asset, if a trader has a portfolio with multiple assets, can give an idea about the risk profile for different traded instruments and help redistributing the risk exposure in positions accordingly.

Calculating drawdowns helps with trading consistency

Keeping an eye on how much your investment drops helps you make smarter decisions in trading. This consistency boosts your chances of making money over time.

Yet, even if your strategy has good rewards and a high success rate, you can't predict the exact order of wins and losses. Sometimes, you'll hit a streak of losses before making gains, which can hurt your funds. But if the losses are small, you should have enough money left to eventually turn a profit.

Being able to handle these losses ensures steady trading for someone with a clear goal in mind. Estimating how much your investment might drop in a specific strategy can help you understand how your funds relate to the time needed to make a profit. Having a clear trading plan will help manage your emotions and make more informed decisions during downturn periods, but it always helps to test new strategies on a trading demo before investing any capital online.