What is drawdown in trading? A drawdown is a peak-to-trough decline during a specific recorded period of an investment, fund, or commodity. A drawdown is usually quoted as the percentage between the peak and the trough.
For example, if an investment has a value of $100 at its highest point and falls to $90, the drawdown is said to be 10%. The depth of a drawdown is typically measured from peak to trough, but the duration can also be important.
There are two types of what is drawdown in trading: absolute and relative. Absolute drawdowns are expressed in monetary terms and reflect the actual loss in value experienced by an investment; relative drawdowns are expressed in percentage terms and indicate how much an investment has declined relative to its highest value.
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Absolute drawdown
An absolute drawdown is a decline in the value of an investment expressed in monetary terms. For example, if an investment has a value of $100 at its highest point and falls to $90, the absolute drawdown is said to be $10.
The depth of an absolute drawdown is typically measured from peak to trough, but the duration can also be important.
Relative drawdown
A relative drawdown is a decline in the value of an investment expressed as a percentage. For example, if an investment has a value of $100 at its highest point and falls to $90, the relative drawdown is 10%.
The depth of a relative drawdown is typically measured from peak to trough, but the duration can also be important.
What is drawdown in trading? Both measures can be useful in assessing the risk of an investment. For example, a stock may have experienced a 50% absolute drawdown during the financial crisis of 2008. Still, if it were previously trading at $100 and fell to $50, its relative drawdown would only be 50%. Measuring the depth and duration of drawdowns can help investors assess the riskiness of an investment and make informed decisions about when to buy or sell.
What Causes Drawdowns?
What is drawdown in trading? Several factors can cause investments to experience drawdowns? Some of the most common include:
– Economic recessions: A recession is a period of economic decline marked by falling GDP, high unemployment, and stagnant or declining prices. Recessions can cause investments to lose value as businesses cut back on spending and consumers reduce spending.
– Market corrections: A market correction is a sharp decline in asset prices after a period of gains. Corrections are often triggered by a change in investor sentiment or an unexpected event, such as a natural disaster or economic data release.
– Company-specific news: Negative news about a company, such as poor earnings results or management shakeups, can cause its stock price to drop. This can lead to drawdowns for investors who own the stock.
How to Avoid Drawdowns?
There is no guaranteed way to avoid drawdowns, but there are some strategies that investors can use to minimize risk. Some of these include:
– Diversification: One of the most effective ways to reduce the risk of drawdowns is to diversify your investment portfolio across several asset classes, sectors, and geographical regions. This will help to protect you from losses in any one particular area.
– Risk management: Managing your risk properly is essential for avoiding drawdowns. This includes things like setting stop-losses and position sizes and using hedging strategies.
– Discipline: Maintaining discipline during times of market turbulence is key. This means sticking to your investment strategy and not selling in a panic when prices start to fall.
– Patience: Investing is a long-term game, and patience is often required to succeed. Selling during a market correction or recession can lead to substantial losses, so it is important to have a long-term time horizon when investing.
