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.
How to Calculate Drawdown
The statistical calculation below can be used to calculate the drawdown amount manually if needed.
Where:
- D(T) = Drawdown Time
- t = Peak
- T = Trough
- X = Variables
The Peak is an all-time high and Through is a current low after the Peak.
Drawdown Example
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.
Other Types of Drawdown
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.
Equity Drawdown
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.
How drawdown can be visualised
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.
Pros and Cons of Drawdown
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:
The Advantages
- Risk management is all about knowing your risk. Forex traders should work on fine-tuning their trading strategy to avoid losses, especially when considering the inherent volatility of the forex market and the typical application of leverage.
- Having a low drawdown can help build confidence in a trading strategy and provide comfort to investors to make larger transactions, individuals who are investing in a managed forex account or traders who are running automated trading systems.
- Knowing how your strategy is doing compared to the rest of the forex market is essential to help ensure you are trading efficiently. Calculating drawdown can help compare your portfolios market volatility to that of a benchmark.
The Disadvantages
Drawdown is a harrowing experience; despite that disadvantage, the mathematical calculation also comes without its drawbacks:
- The method of calculating the drawdown % by subtracting the trough value from the Peak value provides a rough estimate of how the portfolio is performing.
- Drawdown focuses heavily on two extreme ranges and doesn’t consider how many times an account swung up and down between those two ranges unless you observe drawdown on a chart.
- Political and government news and cause a sudden spike in a currency pair. Because of the market-wide event, the drawdown calculation for this current volatility may not be truly reflective of the underlying trading strategy.
- Some traders scrutinise their drawdown percentage, and it can influence them to close positions that are in a pullback to early to protect their stats.
Conclusion
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.
