Drawdown – Stocks
What is a Drawdown?
A drawdown represents the drop from a peak to a trough for an account value. The drawdown is one of the most important inputs for assessing the risk associated with an investment. Many traders overlook the drawdown factor and only focus on the gains.
Why Is Calculating the Drawdown Important?
When analyzing a trading system, a trader must assess how much of their capital is at risk for any given period of time. The drawdown value shows how much of a pullback can occur during a trading series for a portfolio. So, instead of just looking at swing highs and lows on a chart, the drawdown calculation makes the moves in the market tangible to you the trader, because it shows how it will directly affect your money. There are times a trader can begin to see patterns in their trading losses. Are your drawdowns coming in the morning, afternoon, during the summer? When looking back at your system, the drawdown values will assist in providing insight into weaknesses of your system.
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Losing Series in a Drawdown
When traders start out, they want to naturally win on every trade. The reality of the matter is no matter what system you use, there will be losses. During a drawdown period, the run from high to low may come on one trade. But there are times when it could come as a result of 5 or more losers in a row. Traders have to know not only the drawdown that can occur in a trading series, but how many losing trades in a row as well. Being able to look back at a winning trading system and see a number of losers in a row, will provide confidence when your trading system experiences a losing system in the future.
How to Work Around Drawdowns
Drawdowns like anything else in trading can be managed. A trader must look at the drawdown of their system and the amount of cash they have on hand. This will drive the amount of capital that can be used per play and their respective stop loss. So, in summary the drawdown helps mold a trader into the disciplined investor that makes consistent gains.