Drawdown is used by traders to measure any decline in investments over a specific time period and is important as a measure of historical risk when investors look at various stocks and investment funds. It is normally expressed as a percentage and measures the peak to trough movement (the decline) of an investment over a specific time period.
As an example, let us say that a trader buys an instrument at £100 and the price rises to £115, before dropping to £90 and then rising again to £115.
As drawdown measures the distance from peak to trough, it would be calculated as follows:
Peak (£115) minus trough (£90) equals £25.
The drawdown is then calculated as distance (£25) divided by peak (£115), equaling 21.7%.
A drawdown value remains in effect until it moves back above the peak as it is unknown if a lower trough could be formed before the subsequent rise, resulting in a higher drawdown percentage.
It should be noted that traders will often also use drawdown to measure the number of [pips] or points a trade was ‘under water’ before starting to make a profit, rather than measuring the full amount from peak to trough.
As an example, traders may buy USD/JPY at 107.35 in the hope that the price rises.
If the price of USD/JPY drops to 106.90 before then rallying to 107.80, the trader may describe his trade as having only 45 pips of drawdown (107.35-106.90).
In this example, we see that no peak has yet been formed as it is unknown if USD/JPY will continue to move upwards or reverse and start moving back towards the trader's entry point.
- Drawdown is used by traders to measure the maximum downside of a financial instrument or investment fund
- Drawdown is usually expressed as a percentage and measures the peak to the trough price movement over a specific time period
- Traders may, however, use drawdown to express solely the number of pips a trade showed to the downside and not calculate using the peak