Oct 17, 2022 Value Broking 6 Mins 3.0K

It is possible to explain the Drawdown meaning from a trader’s point of view. A drawdown has the largest potential for loss in the portfolio’s value, calculated with the highest peak and the subsequent lowest trough of the investor portfolio. This calculation is different from the loss. It is calculated with the help of the difference between the purchase and selling price of a security. 

Drawdown meaning: Drawdown is a value of an investment that goes down from its highest peak and crosses the highest peak during times. The value of an investment in the drawdown can be lower if the value of securities stays below the last peak for a longer period. Drawdown in the stock market is quite common due to the gauging volatility and several reasons affecting the market conditions. 

So let us understand the drawdown meaning with an example. Drawdown time and the initial value of investments are important factors to consider.  An investor can calculate his return based on a time frame, a month, year or monthly basis. It can begin on a year or a monthly basis if the investment amount is Rs 15 lakh. The highest peak of the investment will be around Rs 20 lakh during a year. So, the return will be around 50% of the investments. When the market condition changes, your investment can go down to Rs 17 lakh. You will still get a potential return, and as per the drawdown theory, the highest peak will be Rs 20 lakhs, the lowest value is Rs 17 lakh, and the drop for the investments will be around 20%.

The Formula to Calculate Drawdown in the Percentage Form Will Be- H2

Drawdown in the form of % = ((Pmax Value – Min Value) / Pmax Value)) * 100

Terms are:

Pmin is at a historically low trough price.
Pmax is the highest peak point of stock price.

Drawdowns mean the decline in the capital trader’s account and, more precisely, the movement of your financial portfolio from a peak to a specific trough.

Why Does Drawdown Matter?

Drawdown is a very important factor for trading in the stock market. Make a proper plan to overlook your financial portfolio. A strategy in the stock market world will give you better decision making and future planning about your stock investment. Even a strategy that says eighty percent of success will not imply that trades 8 out of 10 will be profitable. There is a chance of loss; this is where you can use the Drawdown method.

Drawdowns are a part of trading and risk management in the trading activity. It is one of the best risk management plans and effectively helps the trader prevent heavy losses.

Some of the essential things to know about the drawdowns:

  • Drawdown in the stock market can be stated in percentage or the currency value.
  • It tracks the percentage of impact or damage by a drawdown 
  • You can track the risk that your trading account is facing.
  • A drawdown risk can be represented as a 20% drawdown which will be a drawdown risk of 25%, and if the percentage is around fifty, the drawdown risk will be a hundred per cent.

Drawdown Risk

As you have learned about what is drawdown, you can simply use the drawdown method to analyze and improve your trading strategy.  This type of strategy will help you improve your trading and make accurate decisions that reduce your losses and help grow your trading skills. For example, suppose you face any losses in an asset and face the harsh market condition due to any factors. Then, everything will be simple if you utilize your expertise in drawdown and smartly predict the price movements to optimize your stock investments.

When an asset possesses a low drawdown, it has a lower risk and is considered a stable investment than an asset with a higher drawdown value. Although if you wish to invest in securities with high risk and better returns, you can invest at your own risk, for a stable investment, you can go with a drawdown value of securities. Knowing drawdown meaning also highlights the importance of recovering your investments. The concept of return for your investment will vary on the type and sector of your financial securities. It can take months, years or even shorter to use the asset value towards its peak value. 

The drawdown shows a massive risk for investors seeking profit when the stock trend overcomes a drawdown. A drawdown of 1 % is not a thing to worry about as a stock recovery from 1% will be increased to 1.015 to recover from its last peak price. But if you consider a 20% drawdown, it requires around a 25% return to recover from the old peak. You can check the 2008 to 2009 great recession period in the US stock market, where there will be a requirement of a 100% increase to recover from the former peak value.

Most investors carefully pick the drawdown. The ideal drawdown for them is around 20%. At more than 20% of drawdowns, investors will exit or not choose to trade in that asset. Assume the share price of a Tata steel at Rs.150/- and the price rises to a peak at Rs.160/- and then falls to a trough value of Rs.130/-

Using the drawdown formula, we can calculate the drawdown percentage; the above stock’s peak price is Rs.150/-, and the trough is Rs.130/-. Hence, the drawdown will be 30/160 = 18.7%. 

It shows us that drawdown doesn’t always conclude with loss. For example, the stock drawdown was 18%, but the trader will be getting an unrealized loss of around 12% because the trader views the loss in terms of the purchase price or entry price.

Conclusion

You should have patience, knowledge and experience, which is the key to mastering stock market trading. The market is a completely volatile world where you get the phase such as bull and bear. As someone new to the stock market, it is important for them to know the drawdown meaning and a clear concept of these strategy formulas. Knowing where your financial portfolio is and where it will be in the future is the key to growing and making your investment rise and shine like the sun. You can use these strategies in different types of assets and do better trading in the stock market.

Frequently Asked Questions (FAQs)

Drawdown entirely depends upon the investor’s risk tolerance. For example, you can opt for a higher-level drawdown, whereas a low risk can tolerate the lower drawdown level if you target a higher return.

You must choose a data series with a good metric decision to control drawdown in trading.

To determine volatility in the market, measure the risk that comes with your investments, and manage accordingly, you must use a drawdown in trading.