The drawdown is the retracement of the profit curve from the previous reference maximum to the minimum during a given period.
It is a way of measuring the risk of an investment, a mutual fund or a financial asset. It is usually expressed as the percentage between the reference maximum and minimum. The current drawdown is maintained until the reference maximum is not exceeded.
In the example above, you can see how the investment generates returns over the period. However, in the period it peaks at 90% and falls back to 40%. Until the reference maximum of 90% is exceeded, the drawdown cannot be counted again. In the following example, we can see how there are two drawdowns.
What is really interesting, more than the current value, is the maximum drawdown. In reality, that is, when looking at the results curve of an investment fund or a trading system, we will see many and very small. Therefore, what is truly relevant is the maximum for the entire period.
In the graph above you can see the results curve offered by Morningstar for a real fund. There are several relevant drawdowns throughout the period. The maximum is the second. It is around 20%. Although the latter is higher in absolute terms, it is important to work in percentages.
Drawdown of a trading system
The drawdown is a very important measure of risk in trading systems. The "maximum drawdown" is often used as a concept. That is, when we want to evaluate the risk of a trading system, we measure the maximum drawdown. The maximum drawdown will tell us what the maximum loss of a trading system has been during a period. There can be many small drawdowns, but a very large one. This informs us of the risk involved in the trading system.
The importance is that there is no use in a trading system that generates very large profits if the maximum loss is very large. Since at any time a large part of the capital can be lost.
Importance of drawdown as a risk measure
Regardless of the numbers themselves, assessing risk through this measure is crucial. It is crucial, because the greater the loss, the more difficult it is to recover the gain.
Suppose an investor has 1,000 euros. If you lose 20%, the value of your investment is 800 euros.
To return to 1,000 euros, you must generate 25% (1.25 x 800 = 1,000). If instead of 20%, you lose 50%, the value of your investment will be 500 euros. With which to return to have 1,000 euros you must generate 100%.
In short, the greater the loss, the more complicated it is to return to the immediately previous moment.
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