Last Updated on September 27, 2023 by BFSLTeam BFSLTeam
Based on the expected rate of returns, investment purpose and the investment horizon, investors and traders may have different goals. However, all investors, irrespective of their strategy, have one common objective and that is to cut losses as much as possible. You too may have prioritized this aspect in your trades so far.
And to reduce the possibility of making losses, there are many metrics that you can track and assess before you plan your next trade. Some of these metrics help you assess the potential for loss, while others may evaluate the risk in a particular stock. One such factor is the drawdown.
You may not know what a drawdown in trading is, but you could have inadvertently used it in your stock selection process. Nevertheless, let’s take a closer look at what a drawdown means, how it is measured and how it can help you make more informed trading and investment decisions.
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What is a Drawdown in Trading?
In the simplest terms, a drawdown is the decline in the price of an asset from one peak to the next lowest trough. It is expressed as a percentage and is only measured after the price of the asset has risen and surpassed the earlier peak. Drawdowns can be calculated for any asset whose price changes over time.
The time period over which a drawdown in trading is calculated can also change based on your time horizon. For instance, if you are an intraday trader, you may calculate drawdowns for shorter periods like one hour. Traders with a medium-term outlook may compute this metric for a single trading day or over a week. Meanwhile, long-term investors may be more interested in drawdowns spanning several months or so.
Also Read: What is Stock Market Correction?
What a Drawdown Means: An Example
As the definition of a drawdown indicates, this metric calculates the decline in the price of an asset between a peak and a trough. Let us take an example to understand this better.
| Trading Day | Price of a Stocks |
| Day 1 | Rs. 100 |
| Day 2 | Rs. 95 |
| Day 3 | Rs. 90 |
| Day 4 | Rs. 94 |
| Day 5 | Rs. 87 |
| Day 6 | Rs. 97 |
| Day 7 | Rs. 102 |
From the above data, we can make the following observations:
- The first peak price was Rs. 100 on day 1.
- Thereafter, the price fell and touched the lowest point in the week, at Rs. 87 on day 5.
- Then, on day 7, it surpassed the earlier peak of Rs. 100 and touched Rs. 102.
So, we can only calculate the drawdown after the stock price attains a new peak, as observed on day 7. The drawdown here would be calculated as follows:
Drawdown = (Previous peak — Subsequent Trough) ÷ Peak Value
= (Rs. 100 – Rs. 87) ÷ Rs. 100
= Rs. 13 ÷ Rs. 100
= 0.13
When expressed as a percentage, this represents a 13% drawdown. Do note that although the price rises between day 3 and day 4, we cannot calculate the drawdown in trading on day 4 because that day’s peak of Rs. 94 does not surpass the earlier peak of Rs. 100.
Also Read: 6 Steps to Choosing Stocks for Your Portfolio
How to Use a Drawdown in Your Trading or Investment Strategy?
Now that you have understood what a drawdown means, you need to understand how to interpret it and use it to add value to your trades. There are many ways in which you can use this metric to improve how you participate in the market. Let’s take a closer look at some of them.
- Analyzing Trade Performance
The drawdown for a particular asset or for the market as a whole can be used to analyze how well or otherwise a trade has performed. You can chart the price action and analyze patterns that give you insights into how the trade performed due to the drawdown — in comparison with your expectations.
- Evaluating the Risk-Reward Equation
You can also make use of the drawdown in trading to identify the risk-reward relationship for your trades. By comparing your net returns from a trade with the maximum drawdown associated with that trade, you can see if the risks you took justified the profits you earned. If the drawdown is too high when compared with the reward, it may not be a feasible strategy.
- Setting a Daily Loss Limit
The drawdown over a given time period can also give you a clear idea about the maximum potential loss you could suffer by trading in a given asset. This information can be crucial in setting a daily loss limit, so you can exit your position at the specified limit and cap your losses instead of suffering from a larger drawdown.
- Calculating the Calmar Ratio
The Calmar ratio is computed as the average rate of return over a given period divided by the maximum drawdown during that period. It shows you the returns generated for each unit of risk taken. The higher this ratio is, the better, because it indicates that you have earned higher returns for the risk you’ve taken. In other words, it indicates better risk-adjusted performance.
For example, say the annual return from a stock is 12%, while its maximum drawdown over the past year is 10%. So, the Calmar ratio will be 12:10 or 1.2. On the other hand, a stock with an annual return of 15% and the same drawdown of 10% will have a Calmar ratio of 1.5.
Conclusion
This should give you a better idea of what a drawdown in trading is and how you can use it to improve your trading or investment strategy. If you feel confident enough to understand the market better with this metric, you can devise a trading plan and start trading in the markets. All you need to get started is a demat and trading account — which you can easily open with a trusted stock broker cum Depository Participant like Bajaj Financial Securities Limited.
