What is the drawdown and how it could help you assess the risk of a strategy

What is the drawdown and how it could help you assess the risk of a strategy?

You have probably already heard this term and we have already published an article on the subject. However, we feel it is important to come back to the subject as it is an important tool in strategy selection. As you can see, we are going to talk about the drawdown here! What is it and how to reduce it, we will see all this together!

What is a drawdown?

To assess the caliber of their trading and risk management, traders frequently discuss drawdown or maximum drawdown. A trading account’s excellent performance does not necessarily indicate that the strategy or method being used is profitable and risk-free.

The drawdown is a measurement of a trading strategy’s loss and, hence, risk. A trading method will only lose as much as its maximum drawdown for a given time frame. On websites like Tradingview, the drawdown is displayed as a percentage and as an amount.

The maximum drawdown of a position or trade is the maximum unrealized loss during the entire range. A trade may have been closed at a profit, but still have a significant drawdown. The trader would have let the trade carry a loss, only to cut it to a gain. The drawdown is a measure of risk on a trade by trade basis. It is a more accurate way to measure the “true” drawdown of a trading strategy. Taking into account the latent losses helps to measure the real risk.

How to interpret it?

All things being equal, the lower the Maximum Drawdown indicator, the better the quality of the trading. Indeed, the Maximum Drawdown corresponds to the worst performance that an investor could have obtained by replicating your trades over a given period. Although past performance does not predict future performance, the Maximum Drawdown allows us to estimate the maximum latent loss that an investor will have to bear if he chooses to invest with you.

For example :

Following your strategy A, you make an initial investment of $100, and after a string of largely profitable deals, you have earned $150. A 50% improvement in results is excellent! Following a string of losses, you eventually find yourself at $125 before it rises once more to surpass $150, restoring your capital level from before the series of losses. The drawdown is the percentage difference between the lowest level attained and your capital level. The drawdown in the aforementioned scenario is 16.6%.

Conclusion

The drawdown is one of the most interesting tools when it comes to analyzing the risk associated with a strategy. It allows you to gauge the maximum loss before recovery on your capital and thus choose according to your appetite for risk.

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