Drawdown is a common principle used to measure the volatility of an investment. Drawdown is heavily relied on by all types of investors, including forex traders, to demonstrate the potential risk associated with an investment. A forex trader would typically apply the drawdown function to analyse the performance of their forex trading strategy.
Typically displayed as a percentage (%), and plotted on a line chart to show changes over time, drawdown places a value on the loss of an investors assets or the potential loss, usually after a series of losing trades. Being tied directly to performance and risk management, many forex traders look at drawdown as a way to identify weaknesses in a trading strategy.
The statistical calculation below can be used to calculate the drawdown amount manually if needed.
The Peak is an all-time high and Through is a current low after the Peak.
To provide a simple example of how drawdown is calculated, let’s say, for example, you invest $10,000 in an ETF at the beginning of the year. By the end of the year, the ETF value has decreased to $6,000.
Answer: The account decreased from $10,000 to $6,000 reflecting a 40% decrease.
10,000 (Peak) – 6,000 (Through) = 4,000 ÷ 10,000 = 40%
This calculation looks a lot like how you would calculate profit and loss, but they are not the same. They only look the same because the Peak is equal to the initial investment.
Let’s say in the following year, the value of the ETF grew to a high of $11,000, but once again decreased to $6,000.
11,000 (Peak) – 6,000 (Through) = 5,000 ÷ 11,000 = 45.45%
The drawdown has now increased even though the profit and loss remain the same.
It is important to ensure the Peak and Trough values used for your calculation are from the same investment period. In our example, our investment period spans two years. The account is now at $6,000; however, we would still use the prior Peak value of $11,000 until a new Peak is established. Despite the Peak only being redefined by a new higher value, the Trough value doesn’t necessarily need to be an all-time low. The Through is the lowest-low after a Peak.
There are different ways that Drawdown can be interpreted. You may hear about maximum drawdown, average drawdown and equity drawdown. While each of those metrics can be insightful, equity drawdown is probably the most applicable to forex trading.
Drawdown in forex is usually observed as Equity Drawdown. In the example above, we only looked at the drops and increases in the value of a single instrument. A forex trading account is far more dynamic. When you trade forex, you may be placing many orders in a single day and have several positions open at one time. All those positions are pulling and pushing your trading account equity up and down every single second. Equity drawdown allows you to see the drawdown of unrealised losses in your trading account.
Luckily, you don’t need to calculate the potential upside and downside of every trade you make, because most trading platforms or online tools can process your trading history and visualise this information for you.
Like any tool used in assessing the performance of a forex trading strategy, drawdown has its own set of pros and cons. Drawdown is one tool used to help derive the risk of the trading strategy by comparing the Peak and the Trough values. These considerations should play a role when determining how much weight or value that you should place on the drawdown percentage you calculated. Some of the key advantages of knowing your drawdown include:
Drawdown is a harrowing experience; despite that disadvantage, the mathematical calculation also comes without its drawbacks:
Drawdowns are part of trading, and one of the critical characteristics of being a successful forex trader is coming up with a trading plan that enables you to withstand periods of losses or pullback on your positions. If your positions are larger then your account equity can handle, then drawdown is something to be concerned of. Being aware of your drawdown % can help you build a better risk management technique. Practising strict money management is the cornerstone of any winning strategy. Drawdown is not the only risk and volatility management calculation to keep risk in balance the profits. Forex traders also pay a lot of attention to metrics like the Sharpe Ratio, Sortino Ratio and the Sterling Ratio.