What is drawdown in trading?

In trading, a drawdown describes how much a portfolio is down from its peak before recovering, which can be described as a “peak-to-trough” metric.

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Therefore, it is an essential measure of historical financial risk borne by a portfolio, which makes it a key figure to look at when comparing the performance of different trading fund management strategies.

It is also important to have a look at the time it takes to recover a drawdown when assessing different funds, also called the recovery window.

Understanding drawdown in trading

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Definition

An inevitable part of the financial markets, a drawdown in trading represents a measure of a peak-to-trough decline of your investments or portfolio over a specific time once they have recovered.

The drawdown is often shown as a percentage, but it can also be expressed in absolute monetary terms.

It is important to highlight that a drawdown in trading isn’t the same as a loss - even though many traders see a drawdown as unrealized loss.

While a loss means that your exit price was lower than your entry price with long positions (or higher than your entry price with short positions), a drawdown is just a temporary peak-to-trough measure of a given position.

Formula

Drawdown (in percentage) = [ [(Historical high (peak) – Historical low (trough)] / Historical high (peak) ] * 100

Example

Let’s say you decide to buy 1 Rio Tinto stock at AUD 117.

The price rises to AUD 128 (peak) before heading back down to AUD 107 (trough) and bouncing back above AUD 128.

So the drawdown of your position would be [(128 - 107) / 128]*100 = 16.41%.

Why is drawdown important in trading?

Knowing your drawdown in trading is important to be able to adjust your risk and money management rules to improve your trading strategy and the way you protect your investments against risk.

For investors comparing different funds or investments, looking at the drawdown is a great way to get a sense of the risk held before picking one to invest in. Usually, a lower drawdown in trading will provide more comfort and confidence to investors willing to invest.

Because the Trading Cup contest is a fair contest that aims to rank traders with high risk-adjusted returns that apply responsible trading, our artificial intelligence (AI) Money Manager Ranking algorithm takes into account drawdown to create the leaderboard.

How can you reduce your drawdown in trading?

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There is no one-size-fits-all answer to what a good drawdown in trading is, as it depends on many criteria, such as your risk aversion, your capital, your goals, and your strategy. Still, it is often recommended to keep a drawdown in trading below 20%.

One of the best ways to reduce your drawdown in trading is to use diversification.

As you probably know, diversification is a key concept in modern portfolio theory that theoretically allows you to mitigate risks while increasing your overall profit by investing in different asset classes, currencies, financial products, sectors, countries, etc.

You can also carefully select the assets you focus on to avoid investing in too volatile markets that are likely to widen your drawdown in trading.

Money management tools can also help reduce your drawdown.

You can, for instance, adapt your leverage effect and the size of your trading positions to market conditions, as well as use tighter stop-loss orders and set-up take-profits.

So, are you ready to show the world how well you can manage risk in a live trading competition? Click here to register an account.

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