Drawdown

The meaning of drawdown in financial markets

Drawdown refers to the decline in your trading account from its peak value to its lowest point before recovering. It's typically expressed as a percentage and is a key measure of risk and volatility. As a result, it's useful in determining the extent of your losses during a specific period and can provide insight into potential downside risks.

Why should you monitor drawdown as a trader?

As a trader, tracking drawdown is essential as it can help you to understand the worst-case scenario for your strategy. Deep or prolonged drawdowns may indicate that you're taking excessive risk or have a flawed strategy. By closely monitoring drawdowns, you can adjust your approach to protect your capital and avoid significant losses.

Drawdown vs simple losses: what’s the difference?

Simple losses occur when one of your trades results in a negative return. They should be an expected part of your strategy. You can mitigate through sensible risk management, like using stop-loss orders and carefully considered position sizes. Drawdown, however, measures a more significant, cumulative decline over time.

How drawdown can impact your portfolio’s overall performance

Drawdowns can limit your ability to achieve consistent returns. The deeper they are, the harder it can become for you to recover lost capital. For example – if you experience a 50% drawdown, you'll need a 100% gain to break even again. This illustrates the exponential difficulty of recovery against deepening drawdowns and highlights the importance of an appropriate plan to manage them.

What are the different types of drawdown?

Understanding the different types of drawdown can help you manage risk and evaluate the performance of your strategy. Each type can provide insights into your exposure to loss and aid in selecting appropriate risk management techniques.

Floating drawdown

Floating drawdown refers to the unrealised losses on your active trades before you close them. This type of drawdown, which occurs when an open position moves against your expectations, will fluctuate as market conditions change.

For example, if you entered a long position on GBP/USD at 1.2500 and the price dropped to 1.2450, you'd have a floating drawdown of 50 pips. However, if later, the price rose above your entry level before you closed the trade, the drawdown would be eliminated.

By monitoring floating drawdown, you can assess whether your strategy can withstand short-term market volatility without you having to close your positions early.

Fixed drawdown

Fixed drawdown represents the losses that have been realised after closing your trades. Unlike floating drawdown, these losses are permanent and directly impact your trading account balance. For example, if you start with £10,000 and incur several losing trades that reduce your balance to £9,500, the fixed drawdown would be £500.

By keeping track of fixed drawdown, you'll be better able to evaluate your risk management plan's effectiveness and make necessary adjustments to avoid sustained losses.

Absolute drawdown

Absolute drawdown measures the total decline in your account's balance from your initial deposit. This metric highlights your maximum capital at risk and is useful for determining how much of your starting balance has been lost. Here’s how it’s calculated:

Absolute drawdown = initial balance - lowest balance reached

For example, if you deposit £5,000 and your balance drops to £4,200 before recovering, you'd have an absolute drawdown of £800. As such, this metric can help you evaluate your strategy’s resilience and determine whether your initial exposure to risk will be sustainable over time.

Relative drawdown

Relative drawdown represents drawdown as a percentage of your highest account balance or – peak equity. Since it adjusts for account growth, it provides a more dynamic assessment of risk that can help you keep a stable risk-reward ratio. The formula is as follows:

Relative drawdown = peak balance - lowest balance/peak balance x 100

So, if your account reaches a peak of £12,000 but drops to £10,500, the relative drawdown is:

£12,000 - £10,500/£12,000 x 100 = 12.5%

Understanding and calculating initial and maximum drawdown

By understanding and learning how to calculate initial and maximum drawdown, you'll be able to clearly assess your portfolio’s resilience, improve your risk management, and develop strategies that align with your trading goals.

Initial drawdown

Initial drawdown refers to the first significant decline in your account balance from its starting value. It is useful in gauging the immediate risk exposure after you begin a trading strategy and determining whether it aligns with your risk tolerance.

Formula

Initial drawdown = peak balance - lowest balance

Example: Imagine you start trading with £10,000. However, after several losing trades, your account value drops to £9,200 before recovering. In this case, the initial drawdown would be:

£10,000 − £9,200 = £800

Maximum drawdown

Maximum drawdown (MDD) measures the largest peak-to-trough decline in your account's value over a specific period before a new peak is reached. As such, it can provide insight into the worst-case scenario for your chosen strategy. A high MDD may indicate that you're taking excessive risk, whereas a lower MDD suggests more controlled risk management.

Formula

Maximum drawdown = peak equity − lowest equity/peak equity x 100

Example: Your account grows from £10,000 to £15,000 but then drops to £12,000 before recovering. Here, the MDD would be:

£15,000 − £12,000/£15,000 x 100 = 20%

A 20% MDD means you'd have lost 20% of your peak capital before recovering. This measurement of your steepest decline before recovery can be used to determine whether your strategy can withstand unfavourable market conditions. If it consistently generates a low MDD, it's likely to be more stable and sustainable over time.

What are acceptable drawdown levels?

The drawdown levels you're willing to accept will depend on your risk tolerance, strategy, and goals. There's no universal threshold, so understanding the relationship between risk and drawdown is crucial for ensuring that your approach to trading remains sustainable.

Risk tolerance and maximum drawdown levels

• Low risk
  If you have a low tolerance for risk, you should aim for low drawdown levels. Below 5-10% of your account balance would be typical. To preserve capital, you might want to consider smaller position sizes, setting tighter stop-loss orders, and choosing lower volatility markets. Diversifying your portfolio can also limit your risk exposure.
• Moderate risk
  A moderate-risk approach would require you to accept slightly higher drawdown levels, usually in the range of 10-20%. This may help you find a balance between risk management and potential returns. However, you'll need to ensure you're willing to incur short-term losses for long-term gains, control your leverage, diversify your positions, and optimise your risk-reward ratio to maintain profitability.
• High risk
  Prefer to trade aggressively? If so, and you're using higher leverage and larger position sizes, you'll need to tolerate much higher drawdown levels – potentially exceeding 20-30%. While you may generate greater profits with this approach, there's also a higher chance that you'll experience account wipeout – which refers to losing your entire balance. Making sure you have ample short-term focus, a suitable recovery plan, and a platform with rapid trade execution – like Pepperstone – is crucial in mitigating loss while high-risk trading.

Drawdown analysis: why is it important?

Drawdown analysis is a crucial aspect of risk management, which can help you assess the long-term sustainability of your strategy. By understanding and controlling drawdown, you can protect your capital, avoid unnecessary losses, and potentially improve overall profitability.

Evaluating long-term profitability and securing sustainable growth

Your trading strategy’s success is measured by how well it withstands periods of losses – not just the number of winning trades. If you have a strategy with a low, controlled drawdown, it's more likely to keep generating profits in the long run. Therefore, managing your drawdown levels can prevent your profits from being impacted by sharp declines, and enable you to keep trading for longer.

Controlling drawdown is also essential for compounding profits and maintaining steady portfolio growth. As mentioned earlier, large drawdowns require significant percentage gains to recover, which can be difficult to achieve. Making sure your drawdowns are smaller, however, will allow you to recover losses more easily, potentially leading to more consistent, long-term gains.

Avoiding account wipeouts

Excessive drawdown levels can wipe out your account, making it impossible to continue trading without making another deposit. Analysing your drawdown tolerance and employing effective risk-management techniques, which we'll cover in the next section, can help keep you in the markets without being forced out by unsustainable losses.

Strategies for managing drawdown

Effectively managing drawdown is essential if you want long-term trading success. By using robust risk-control measures like position sizing, leverage control and diversification, you give yourself the best chance of minimising potential losses, preserving your capital, and ensuring your approach remains sustainable when the markets move against you.

Risk-management techniques

Consider the risk-management procedures below to reduce the likelihood of experiencing severe drawdowns:

• Watch your position sizes: Adjust your trade sizes according to your account balance and risk tolerance to ensure that a single loss does not significantly affect your overall capital. A 1-2% risk per trade rule is commonly used by traders to effectively manage losses.
• Be conservative with leverage: Leverage can amplify profits, but it also poses increased drawdown risk. Excessive leverage use may result in margin calls or – in the worst case, account wipeout. So, make sure you use an amount that aligns with your risk tolerance to stay in the game.
• Diversify your trades: Spreading your capital across different assets and markets can help to minimise risk by increasing the chances of offsetting the losses of losing trades with others that move in your favour.

Portfolio rebalancing

Adjusting the allocation of your underlying assets is important in managing drawdown. This is because fluctuations in market conditions over time can impact your portfolio weightings and potentially increase your exposure to high-risk assets.

To rebalance if drawdown becomes excessive or market conditions become unstable or uncertain, you can:

• Reduce your exposure to highly volatile assets.
• Allocate capital to lower-risk assets.
• Gradually increase position sizes upon stabilizing market conditions.

Using stop-loss orders

A stop-loss is a trading tool which can minimise your exposure to drawdown by automatically closing losing trades before losses intensify. There are two types of stop-losses you can use:

• Fixed stop-losses: These close a trade at a predetermined level
• Trailing stop-losses: These move with market prices, helping you secure profits while reducing risk.

How to recover from drawdown

Experiencing drawdown is an expected element of trading, but how you respond to it determines your long-term success. To recover effectively, you must identify the causes, adjust your strategy, and keep psychologically resilient.

Identifying the causes of drawdown and adjusting your strategy

Before you change the way you trade due to drawdown, you should first take a look into what contributed to it. Were market conditions like news events, economic shifts or unexpected volatility to blame for your losses? If so, double down on your pre-trade research to inform your new approach. Perhaps you made a few trading mistakes, such as using excessive leverage, failing to consider proper risk management or not sticking to a plan. In this case, reviewing your trades can shed light on performance-limiting patterns that require correction.

Once the causes are clear, you can adjust your strategy to reduce the impact of future drawdowns by reducing your trade sizes and risk exposure to further losses while regaining confidence.

Maintaining psychological resilience

Emotional control is key to navigating drawdowns. To be a successful trader, staying disciplined and following a structured recovery plan is essential. Therefore, it is important to:

• Avoid revenge trading: Accept that the drawdown has happened and make sensible adjustments rather than impulsive trades.
• Keep patient: Recovering your balance can be a long process. Don't be tempted to trade with excessive risk to chase your losses.

Also, consider taking a short break from trading to regain focus and prevent emotional trading errors.