Drawdown on a Trading Account
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What is the Drawdown?
Traders generally talk about drawdown or maximum drawdown to judge the quality of their trading and risk management. Effectively, strong performance on a trading account does not mean that the trading strategy applied is really profitable and without risk.
More simply, drawdown measures a trading strategy’s loss, and therefore its risk. The maximum drawdown over a given period is the maximum loss recorded by a trading strategy over that period.
Drawdown can be calculated as an amount or as a percentage.
Example: A trader could talk about a drawdown of €150 or 1.5% on his €10,000 trading account.
The maximum drawdown of a position or trade is the maximum unrealized loss recorded during the entire range. A trade may have been closed with a win/profit, while registering a large drawdown. So the trader would have left his trade in loss, and finally cut it in profit. The drawdown makes it possible to measure risk, trade by trade.
The maximum drawdown of a portfolio, or trading account, is the maximum unrealised loss recorded during the entire range of all open trades. The drawdown of a portfolio or a trading account therefore accumulates all the latent performances of the open positions.
Finally, it is important to know that traders usually couple their maximum drawdown with the Profit Factor to get a better statistical view.
Don’t confuse Performance Drawdown and Drawdown Risk
These notions do not really exist but it is important to distinguish the drawdown which includes all maximum latent losses added together (all trades combined), from the drawdown calculated only on final performance (closed trades).
An example to help you understand:
A trader opens 3 trades:
Trade 1: result: +€10 Maximum latent loss during the range of the trade: -€10
Trade 2: result: -€20 Maximum latent loss during the range of the trade: -€40
Trade 3: result: +€50 Maximum latent loss during the range of the trade: -€20
If this trader told you he had a drawdown of €10, he would be talking about what I call the ”performance drawdown” .
Effectively, trade 1 earned €10, then trade 2 lost €20 (so a maximum drawdown of -€10), to finally gain €50 with the last trade. This also includes that trades were inevitably skipped, one after the other. Which is not necessarily true.
If this trader told you he had a drawdown of €40, he would be talking about what I call the “drawdown risk”.
Effectively, the trader is talking about the maximum latent loss of one of his 3 trades. NB: the question is, knowing whether the 2 other trades had performed well at another time, because otherwise the maximum drawdown would be the sum of the latent capital gains.
Examples to clarify maximum drawdown
Example 1 to clarify maximum drawdown per trade:
A trader opens 5 trades during the day. One trade at a time.
Trade 1: result: +€20 Maximum latent loss during the range of the trade: -€10
Trade 2: result: -€10 Maximum latent loss during the range of the trade: -€40
Trade 3: result:+€50 Maximum latent loss during the range of the trade: -€20
Trade 4: result: -€60 Maximum latent loss during the range of the trade: -€60
Trade 5: result: +€50 Maximum latent loss during the range of the trade: -€20
In total, the trader generated a capital gain of €50 on this trading day, with a maximum drawdown of €60 (trade 4).
Is that good?
Not really. This implies that the maximum latent loss on a single trade was greater than the total performance of the day.
In other words, just one trade made more loss.
Example 2 to clarify maximum drawdown on a portfolio/trading account:
Let us imagine that this same trader opened these same 5 positions but at the same time, and that the maximum latent losses were made at the same time.
In total, the trader generated a capital gain of €50 on this trading day, with a maximum portfolio drawdown of €150 (sum of all maximum unrealised losses).
Is that good?
Not at all. This implies that to get €50 of profit, the trader suffered a total unrealised loss of €150 (3 times more!) at a given moment.
The trader may conclude that his strategy is very risky. Even if in the end the trader is the winner, every day he risks recording a severe loss that he will have difficulty to cover with his trading strategy’s future trades.
The major advantage of drawdown
Drawdown is an indelible mark in the risk of a trading strategy. Effectively, maximum drawdown is fixed value which cannot be decreased. Maximum drawdown can only increase, increase, increase, but never be reabsorbed.
If you hear a trader bragging about having an infallible trading strategy, ask him what his drawdown is? He will answer you first by talking about his "fake" drawdown, which does not include unrealized losses on all trades at any time, but only the maximum losses recorded. By continuing to ask him questions, he will simply end up not answering the question about "real" drawdown. He will certainly turn the conversation back to his global performance.
Maximum drawdown is therefore an excellent instrument to determine a strategy’s quality, and a formidable addition to the Profit Factor. You will now understand, quite easily, why it is better to appreciate a trader who shows +10% performance with a maximum drawdown of only 2%, rather than a trader who shows a 20% performance with a drawdown of 20% (or more).
