Drawdown Definition And Example
A drawdown happens to every trader and investor once or many times for their career. No matter how diversified their portfolio is, they suffer from drawdowns from time to time. The only thing that a trader or an investor can do is accept, assess and survive this period.
What is a drawdown? This is a percentage between the maximum and the minimum price, the top and the low of a trading account. A drawdown can be easily seen in the next example. Let’s imagine a trader has $10,000 on his trading account. His funds drop to $7,000 and then move back to $10,000. The drawdown of the trading account was 30% in this case.
Assessing drawdowns help traders and investors to calculate trading performance or historical risks for a particular asset. A drawdown should be distinguished from a loss. The first means risks that a person takes without exiting the market, while losses mean that the position is closed.
There are several ways to hedge from drawdowns. The most popular and effective method is to diversify the assets. By using this strategy an investor is able to significantly decrease the drawdown rate or even stay above zero. How to diversify the investments? There are different ways to do it starting from buying different assets of one type and ending with purchasing different types of assets.
The easiest way to understand the diversification is to imagine a trader who buys Apple stocks. He decides to spend another portion of his funds to purchase some car producers stocks, indexes, etc. If the high-tech industry feels bad at a particular moment in the future, he may rely on other assets to hold him above water. However, this may end up with even worse drawdown if the whole economy goes down. Precious metals is the best way to diversify such a portfolio in this case.
Time to Recover a Drawdown
It is almost impossible to predict the end of a drawdown as it depends on the price of the assets in the portfolio and no one knows when the assets will resume their growth in the future. However, there are different analysis tools that help traders and investors to understand the borders of a particular price movement. A speculator can use the following:
- Trend indicators (Moving Average).
- Oscillators (like RSI, Stochastic etc) to see the closest reversal possible.
- Volume indicators.
Using any way of market analysis may tell you the approximate time when the assets will start to recover.