What is a Drawdown?

Investing without a strategy is like sailing without direction. The market is volatile and keeps moving in a bearish or bullish direction every day. To commence your trading journey the right way, it is necessary to understand the important terms and concepts that mitigate risks, optimize gains and maximize the value of the portfolio. Drawdown is one such concept of the market that helps to understand the market volatility and signals to take entry or exit from an investment at the right time.

A drawdown is the largest relative trough in an investment, following the highest relative peak in the value of an investment. It is often used to determine the potential of maximum loss during a particular investment tenure. Simply put, a drawdown is a record low value of investments between two consecutive highs during a particular period. It is a relative term and is measured in percentage.

Drawdown clears the concept of relative and absolute profit measurements. Usually, the returns on investment are calculated for a particular time which can be monthly, quarterly, yearly, and so on. While in the case of drawdown, it is considered to find relative profitability as it is for any given particular period.

Therefore, total gains from investment might be less than the probable maximum gain, by exiting at the right time. The drawdown also helps in setting terms or tenures for future financial goals using historical rates.

Suppose there is an investment portfolio of Rs. 10,000. If this value falls by Rs. 1,000, there is a drawdown of 10% before it reaches the same level of Rs. 10,000. Drawdown in trading is helpful to measure the risk while being knowledgeable about the historical risks of different stocks and their performance.

Maximum drawdown explained

Under the concept of drawdown, there is a term called maximum drawdown. Maximum drawdown refers to the maximum downfall during multiple two peaks and troughs. This concept of drawdown in trading is used to analyze the pattern while comparing two stocks. It gives a clear picture of the investment’s capital preservation potential. As it is a relative metric, this concept is used with other rules to compare the assets.

Drawdown helps an investor to understand turbulence in the market to make better-investing decisions. Longer the value of an invested amount that stays below the peak price, the more the chance of a lower trough, resulting in a bigger drawdown amount.

Importance of drawdown

The historical drawdowns of investments help to understand a pattern of probable troughs and peaks. This eases the exit opportunity from the market with a high-profit margin. It also helps to analyze the market situation, to enter at the right time.

Knowing what is drawdown in trading is important as it gives an idea of the risk to return ratio for a particular stock. If a trader is expecting higher risks, they may opt for stocks with a higher drawdown ratio and vice versa. Keeping in mind what drawdown means while diversifying portfolios makes it possible to select avenues according to the drawdown ratio. A wisely selected portfolio with a lower drawdown ratio can give moderate returns, while a higher drawdown ratio will give higher returns.

Risks of drawdown

Drawdown is a relative measure and it is not an absolute loss. This implies that It is a temporary decline in the value of an investment, while loss is realized when investment is cashed by selling. This is a bigger misconception about new investors or traders.

Another risk of drawdown is the uptick percentage. The uptick is a percentage gain required to regain the previous peak level from the trough. A 2% decline in the stock wouldn’t look much, as the recovery rate would be 1.02% But, a drawdown of 20% requires a recovery rate of 25% and a drawdown of 50% needs a recovery rate of 100%, to recover from the trough. A novice trader may not completely comprehend these figures and take wrong calls while trading in the market.

Final Words

To conclude, drawdown is a way to make better investing decisions by determining the rise and fall in the market. Try implementing your understanding of drawdown in trading and lower the gap of the losses in the hindsight of the volatile market by creating a free Demat account with IIFL.