A quick guide to drawdowns’ definition and common use
According to Merriam-Webster, drawdown is the process of depleting.
In financial terms, we’re going to add to the simple definition and further define it as a measurement of any performance and how much it can absorb a loss before it goes into profits.
A drawdown is related to a single position where you enter the position and the price may go against you and put you in a relative loss before going up once again.
It is also used to be measured on a whole portfolio where you take the winners and the losers together to determine what was the highest sequence of accumulating losses in the portfolio.
A Fancier Way to Say Losses
Drawdown is really just the mathematical expression for losses. As a mathematical expression it can therefore be defined via different types of equations. In financial markets, there are 2 types of equations (drawdowns) that are usually discussed. There is the absolute drawdown and there is the relative drawdown and each calculation is relevant to a different class of investors.
Investors that are not actually measuring performance, those that are only concerned with bringing returns only care about the absolute drawdown.
Whereas a trader who should always be considering his or her performance efficiency should care more about relative drawdown. These traders will tend to care more about how much they can risk as opposed to the initial investment amount.
The Relative Drawdown
The determination of this first type of drawdown begins where the pivot point is at the highest peak of value of the portfolio. For example, if you have a 50k account and you make it up to 55k but then fall down to 40k, then the drawdown is counted from the 55k to the 40k.
The trading behavior is capable of making that consecutive loss from 55k to 40k which is greater than a 20% change.
The Absolute Drawdown
For the absolute drawdown, the pivot point would instead be from 50k to 40k which is only a 20% change. This is the main difference between the two types.
Here’s another example: We have the same 50k and the trader brings it up to 60k. That’s a 20% gain. But then, from the 60k account, the portfolio went all the way back down to 50k. In terms of absolute drawdown, it’s 50k divided by 50k. That’s 0 in drawdown. Apparently no damage is done.
Applying it to a Trader’s Risk and Skill
On the other hand, if we want to measure the skill of the trader on this account, this trader managed to make 20% but they also managed to lose it in consecutive trades. This tells a lot about the way the trader handles money. It tells analysts that the trading style is capable of losing 10k from 60k portfolio.
If we extend this example, after the gain of 60k, the portfolio goes down to 55k. On the absolute drawdown, it’s a gain of 10%. This is a positive gain according to absolute drawdown, while the relative drawdown is 5k. This means the trading activity is capable of having 5k decreasement in the investment.
It’s very important to understand your trading style to determine what the maximum risk you’re willing to maintain in the strategy.
Investors Vs. Traders
If you were an investor doling out money, you would probably be more interested in absolute drawdown. What you’re expecting is outstanding performance from the pivot point which is your initial investment.
On the other hand, if you’re a trader, you’ll always need to measure yourself statistically, from a relative drawdown. From any given point, your strategy combined with your trading manners is capable of making that amount of possible loss. This will define how risky your strategy is. This is very important to measure and work on so you’re always aware of what your possible risk is.
Applied to The5ers Trading Fund
The5ers trading fund measures relative drawdowns when it comes to bringing traders on board. The5%ers always wants to know how much risk a trader may take. This gives us a better profile of much money we’re willing to risk in each trader.
By knowing the relative drawdown a trader is capable of and by plotting the maximum relative drawdown the fund may allow, this is the funds way of profiling and understanding what type of trading performance can participate in the program.
But even if you don’t participate in the5%ers program, you should be aware of your relative drawdown while you’re trading. If you make 100% profit but then lose 100%, it doesn’t make sense to say that you had 50% drawdown. It’s not being honest about how you risk your money.
As always, it all boils down to being honest with yourself and understanding your risk and knowing how to manage it.