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The Devil is in the Drawdown

by on April 12, 2014 7:58 pm BST
 

Drawdown is a concept many beginners do not focus enough time on. It is the difference between the account’s equity low and equity high as expressed as a percentage of the total trading equity. If a trader had no losing trades, then the account would not experience drawdown.

Drawdown begins on the trader’s first losing trade, and it continues as new equity lows are made. It is not an overall measure of trading performance, but it measures the capital loss that was incurred to achieve any success.

For instance, let’s say a trader has an initial account balance of $10,000, and the first trade went bust for a $1,000. That is a 10 percent drawdown and will continue as long as the trader continues to lose capital. Now on the second and third trade, the trader made $500 and lost $750. The new drawdown would be 25 percent ($9,000 + $500 – $750 = $8,750). Drawdowns can be recovered after a new equity high. The trader battles back, and have an overall balance of $13,000. If the next several trades accumulated $2,000 in losses, the new drawdown would be 15.4 percent ($13,000 – $2,000 = $11,000).

How can this be avoided? The answer is simple, risk management. This can be done by having clear entries and exits, as well as proper stop-losses. The only way to manage drawdowns is to manage loses. Whether a professional or beginner, the odds of winning every trade is next to impossible, so manage the losers. Live to trade another day.

Also, keep in mind that drawdowns should not vary depending trading style or system. Professional institutions expect low drawdowns, typically under five percent. You may not be a professional trader, but there is no reason you cannot instill the same fundamental principles. There is nothing to prove in trading, more so when your account is wiped out.