A drawdown is the extent to which the value of an investment or trading account decreases from its peak before rebounding to that peak. Typically expressed as a percentage, drawdowns may also be stated in dollar terms if relevant to a specific trader, serving as a metric for downside volatility.
While a drawdown is often represented as a percentage, such as a portfolio declining from $10,000 to $7,000, resulting in a drawdown of 30%, it is advisable for investors and traders to maintain drawdown below the 20% threshold. This precautionary measure allows for informed decision-making in the market, ensuring the protection of capital over the long term.
It's crucial to differentiate between drawdown and loss; drawdown is a temporary decline in investment value, whereas a loss is realized when the investment is sold. This distinction is important for investors and traders, and misconceptions can arise, particularly for newcomers. Another associated risk of drawdown is the uptick percentage.
Maximum drawdown (MDD) is a measure of the largest price drop an asset experiences from a peak to a trough. It is indicative of downside risk, with larger MDDs suggesting potential volatility in downward movements.
Drawdowns pose a notable risk to investors, especially when considering the upward percentage required for a share price to recover from a drawdown. For instance, a 1% loss may seem inconsequential, but it necessitates a 1.01% increase to return to the previous peak.
