In financial trading, the drawdown represents the amount of money a trader can lose or has lost, following a series of losing trades.
This is measured from the high of the trader’s capital to its low, over a given period of time.
This is usually expressed as a percentage of a trader’s account.
The current drawdown is simply the amount of money a trader’s balance has been reduced by in a given time, without necessarily closing out at that point.
For example, if a trader placed an initial deposit of $4000, and started off suffering losing trades with his equity falling to $3000, in this case the trader’s drawdown would be $1000.
When devising or refining a system, one of those most important statistics is the maximum drawdown.
Traders typically back-test their systems in order to see what the maximum drawdown would have been over a specified time period.
Assessing historical maximum drawdown by way of back-testing helps to inform the trader concerning the sustainability of the trading system.
Why Drawdowns Matter for Traders
Drawdowns are a necessary part of trading, since it’s impossible for a trader to have continuously winning streaks of course.
The most successful traders are those who can devise a trading strategy which allows one to be able to handle long periods of losses, because these periods can and do occur.
Any trader unprepared for such a scenario is putting their account at great risk.
Thus, one of, if not the most important facet of trading is risk management, and knowledge of a strategy’s maximum drawdown facilitates in determining a particular investment's financial risk.
Despite extensive testing of a system’s historical drawdown, it’s never going to be sufficient proof that even further extended periods of losses won’t occur.
