Drawdown
A drawdown is a peak-to-trough decline during a specific period for an investment, trading account, or fund. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. If a trading account has $10,000 in it, and the funds drop to $9,000 before moving back above $10,000, then the trading account witnesses a 10% drawdown.
Drawdowns are important for measuring the historical risk of different investments, comparing fund performance, or monitoring personal trading performance.
The Drawdown Explained
A drawdown remains in effect as long as the price remains below the peak. In the example above, we don’t know the drawdown is only 10% until the account moves back above $10,000. Once the account moves back above $10,000 then the drawdown is recorded.
This method of recording drawdowns is useful because a trough can’t be measured until a new peak occurs. As long as the price or value remains below the old peak, a lower trough could occur which would increase the drawdown amount.
Drawdowns help determine an investment’s financial risk. The Sterling ratios use drawdowns to compare a security’s possible reward to its risk.
A drawdown is the negative half of the standard deviation in relation to a stock’s price. A drawdown from a share price’s high to its low is considered its drawdown amount. If a stock drops from $100 to $50 and then rallies back to $100.01 or above, then the drawdown was $50 or 50% from the peak.
Example of a Drawdown
Assume a trader decides to buy Apple stock at $100. The price rises to $110 (peak) but then swiftly falls to $80 (trough) and then climbs back above $110.
Drawdowns measure peak to trough. The peak price for the stock was $110, and the trough was $80. The Drawdown is $30 / $110 = 27.3%.
This shows that a drawdown isn’t necessarily the same as a loss. The stock drawdown was 27.3%, yet the trader would be showing an unrealized loss of 20% when the stock was at $80. This is because most traders view losses in terms of their purchase price ($100 in this case), and not the peak price the investment reached after entry.
Continuing with the example, the price then rallies to $120 (peak) and then falls back to $105 before rallying to $125.
The new peak is now $120 and the newest trough is $105. This is a $15 drawdown, or $15 / $120 = 12.5%.
