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A drawdown refers to a decline in value that occurs over a certain period for an investment, trading account, or fund. Drawdowns provide valuable insights into the historical risk of various investments, allowing for comparisons of fund performance and monitoring of personal trading performance. Typically, it is expressed as a percentage representing the difference between the highest point and the following lowest point. If a trading account starts with $10,000 and experiences a temporary decrease to $9,000 before recovering to surpass $10,000, it can be said that the account went through a 10% drawdown.
If you don't want to allow big drawdowns, but aim to take the forex challenge and compete with the best, you will find a lot of valuable knowledge on our website that will help you do that.
Exploring Daily Drawdown
As previously mentioned, a drawdown refers to the decrease in the value of an investment or trading account from its highest point until it returns to that same peak. The Ulcer Index (UI) assists in monitoring these fluctuations. It stays valid as long as the price stays below the highest point. In the given example, the decline is merely 10% until the account surpasses the $10,000 mark again. After the account exceeds the $10,000 mark again, the drawdown is duly noted.
This approach to documenting declines is valuable as it is only possible to gauge a low point once a subsequent high point is reached. If the price or value stays below the previous peak, a lower trough may occur, resulting in an increased drawdown amount.
Drawdowns play a crucial role in assessing the financial risk associated with an investment.1 The Sterling ratios utilize downturns to assess the potential gain in relation to the associated uncertainty of security.
A drawdown can be described as the downward movement in a stock's price, representing the change from its highest point to its lowest point. As an illustration, suppose a stock experiences a decline from $100 to $50 but later rebounds to $100.01 or higher. In this case, the decrease from the highest point would be $50 or 50%.
Potential for Losses
Declines in investment value pose a substantial threat to investors, especially when factoring in the increase in stock price required to recover from a decline.
Take this scenario: a stock experiences a seemingly insignificant 1% decline, but keep in mind that a mere 1.01% increase would be sufficient to restore it to its previous peak. However, in order to recover the last peak, a return of 25% is needed after experiencing a 20% drawdown. Experiencing a significant 50% decline, witnessed during the tumultuous period of the 2008 to 2009 Great Recession, necessitates an astounding 100% surge in order to regain the previous peak.
Confident investors opt to avoid significant declines exceeding 20% before mitigating their losses and converting their position into cash.
Assessment of Drawdowns
Minimizing the potential for drawdown risk involves maintaining a portfolio that is adequately diversified and being aware of the duration required for recovery. If an individual is in the early stages of their professional journey or has a significant amount of time until retirement, the recommended drawdown limit of 20%, which is commonly advised by financial experts, should be adequate to protect the portfolio and allow for potential recovery.
Retirees must exercise caution regarding the potential risks associated with drawing down their portfolios. This is particularly crucial as they may have limited time for their portfolios to bounce back before they begin withdrawing funds. Spreading out investments across a variety of stocks, bonds, precious metals, commodities, and cash instruments can provide a level of security during a market decline, as each asset class responds differently to market conditions.
It's important to differentiate between stock price fluctuations or market downturns and the process of drawing down retirement funds. Retirement drawdowns involve the process of retirees taking out money from their pension or retirement accounts.
Examples of Daily Drawdown Rules
Example 1: Account without any Drawdown Add-On
During a simulated challenge with a fund of 100K, if you have an active trade with a floating profit of $2,000 between 4:57 pm - 5:03 pm EST, your simulated equity in the demo account will increase to 102K. Assuming a 5% daily drawdown, it is essential to note that the simulated equity cannot go below $97,000 on the next trading day. This is calculated by subtracting $5,000 from the previous day's equity of $102,000. The calculated simulated drawdown is determined using the starting balance of the demo account.
Example 2: Utilizing the Drawdown Add-On Account
During a virtual Standard Simulated Challenge, if you have an open trade with a simulated floating profit of $2,000 between 4:57 pm - 5:03 pm EST, your demo account equity will increase to 102K. Assuming a 6% daily drawdown, it is essential to note that the equity should not fall below $96,000 ($102,000 - $6,000 = $96,000) in the upcoming trading day. The starting balance of the demo account determines the drawdown.
Example 3: Drawdown-Free Enhancement
In another scenario, during a virtual fund's Standard Challenge with a balance of $100,000, if you have a trade open between 4:57 pm - 5:03 pm EST and it incurs a simulated floating loss of -$2,000, your demo account equity will be $98,000. Due to the fact that your simulated funds balance exceeds your equity, the daily virtual drawdown limit of $5,000 will be calculated based on your $100K demo balance. For the upcoming trading day, the equity must remain above $95,000, calculated by subtracting $5,000 from the initial amount of $100,000.
Example 4: Utilizing the Drawdown Add-On
In another scenario, during a simulated fund's Standard Challenge, if you have an open trade with a floating loss of $2,000 between 4:57 pm and 5:03 pm EST, your account equity will amount to $98,000. Due to the higher balance of your demo funds, which is $100,000, compared to your demo equity of $98,000, the daily drawdown limit of $6,000 will be calculated based on your demo funds balance. For the upcoming trading day, the equity must remain above $94,000, which is calculated by subtracting $6,000 from the initial amount of $100,000.
Example 5: Drawdown-Free Add-On
If there are no active trades by 5.00 pm EST, the daily loss will amount to 5% of the closing balance in the demo account.
Example 6: Utilizing the Drawdown Add-On
If there are no active trades by 5.00 pm EST, a daily drawdown of 6% will be applied to the closed demo balance.
When it comes to investing, there is a thin line between making a profit and losing money. Understanding some of the complexities involved in the world of investments could help you stay in the game. If you can appreciate drawdowns and how they assist in evaluating risk and comparing assets, you can improve your trading skills and reduce the amount of money you lose. Also do not forget that you will be protected from drawdowns by a consistent trading strategy, because the more consistent you are in trading, the more successful you are.