What is drawdowns in trading and how to manage them?

Striving for complete control over the markets is a goal shared by most traders. Ideally, this means eliminating all losses, refusing to make decisions influenced by emotions, and never making trades based on irrational criteria. Unfortunately, it is impossible to predict all market movements and navigate without making mistakes. In trading, as in investing, periods of loss, known as drawdowns, are a fact of life. How to manage drawdowns in trading? Let's find out in this article.

What do I need to know about drawdowns in trading?

A drawdown in trading is a decrease in a trader's capital compared to the previous peak over a certain period. It is often expressed as a percentage, but can also be defined in dollars if it is more relevant to a particular trader. For example, if your trading account balance reaches 10,000 euros, then drops to 9,000 euros before rising back above 10,000 euros, this means that your account has experienced a drawdown of 10%.

It should be noted that drawdown is important for assessing the volatility and risks associated with an investment. It measures the depth of the drop from the previous peak. Thus, it gives an indication of how an investment or trading account may behave in unfavourable market conditions.

Difference between drawdown and losses

It should also be remembered that drawdown is not only a measure of losses but also a measure of volatility. When the value of an asset or account remains below its previous peak for an extended period, the potential drawdown increases. This means that recovery may take more time and effort. Moreover, when a trader estimates drawdown, he or she should definitely consider the time it takes to fully recover from a drop.

Moreover, a short-term drawdown is easier to manage than a long-term drawdown, as the speed of investment recovery is a crucial factor. However, it is also necessary to distinguish between drawdowns and losses. In general, drawdowns refer mainly to the peak-to-trough performance. Losses are generally the difference between the purchase price and the current asset price or exit price.

How to calculate trading drawdown?

To calculate the trading drawdown, it is necessary to determine the maximum capital reduction relative to the previous maximum. This indicator is usually expressed in per cent. Let's consider an example: the initial capital is 100 euros. To determine the drawdown, you need to compare this amount with the highest point that your account reached. Let's say that the maximum value of the account was 120 euros, and then it decreased to 70 euros. The drawdown will be equal to the difference between these values - 50 euros (120 euros - 70 euros).

The formula for calculating the drawdown as a percentage is as follows: Drawdown (DD)% = ((Pmax - Pmin) / Pmax) * 100. Where Pmax is the maximum capital level you reached and Pmin is the minimum capital value after the previous peak.

Drawdowns reflect the drop in capital in a trader's account, specifically from peak to trough. Therefore, it is important to note that the bottom can only be determined after a new peak has been reached. You should also realise that drawdown does not represent a loss per se, but a movement from peak to trough in relation to the original deposit amount.

One way or another, drawdowns are inevitable in trading. For example, if your capital peaked at 150 euros and trough at 110 euros (starting from an initial capital of 100 euros), your total drawdown would be 40 euros (150 euros - 110 euros). Although your portfolio may have made a profit of 50%, you still recorded a drawdown of 27% over this period.

How important are drawdowns in trading?

The importance of drawdowns in trading and investing cannot be overemphasised. Drawdowns serve as a barometer for assessing the risk and resilience of a portfolio. They reflect the reality that financial markets are subject to volatility and fluctuations. Moreover, they can have a significant impact on an investor's capital.

The most important aspect of drawdowns is their relationship to returns. The larger the drawdown, the more effort is required to return to the original capital level. For example, a 1% drawdown does not seem alarming, as it requires a return of 1.01% to get back to the previous level.

However, a drawdown of 50% requires a return of 100% to recover the original investment. This is a much more difficult task, and in some situations, impossible. The percentage required to recover the drawdown is often referred to as ‘drawdown risk’. This emphasises the potentially huge problem associated with recovering funds.

How can trading drawdowns be reduced?

To reduce drawdowns in trading, there are a few important tips to follow. Diversification plays a central role in reducing the risks associated with drawdowns. Therefore, try not to concentrate all your investments in one area. By diversifying your portfolio, you will be better able to withstand severe market downturns. For example, holding gold can act as a hedge against inflation and periods of recession, while adding equities can provide growth opportunities. Don't forget about commodities, such as oil, whose demand increases as the economy grows. A well-balanced diversification will help minimise drawdown.

Proper risk management is a fundamental principle for any trader. Even with a sound trading strategy, poor risk management can lead to significant losses. Therefore, avoid positions with excessively large lots and maintain consistency in order sizes. This will allow you to accurately determine the amount you risk losing in each trade. In this way, you will have better control over your investments. Moreover, more control means less potential drawdown.

Conclusion

Drawdowns can seem daunting, but if you learn how to properly assess and manage them, they can be a useful tool for analysing risk and developing smarter strategies. The better you understand your drawdowns and the better you can manage them, the more confident you will be able to move towards your financial goals, turning temporary setbacks into stepping stones to success.