stocks

What Are Drawdowns in Stock Market Investing?

Stock Market Guides is not a financial advisor. Our content is strictly educational and should not be considered financial advice.

Drawdown is a term that is sometimes used in the stock market when referring to your trading account balance.

Understanding what a drawdown is can be an important part of keeping track of your account's performance and of assessing the risk involved with any given investment opportunity.

 

Drawdown Definition

The formal definition of drawdown is as follows:

So in other words, any time your investment account goes down in value, that's considered a drawdown.

 

How To Analyze Drawdown Information to Make Investment Decisions

The trading strategies we feature in our service here at Stock Market Guides all have a backtested edge.

But when considering any given investment, the potential reward is not the only aspect to consider. Risk is also an important part of the equation.

Example of the Risk Involved with Trading

For one of the stock swing trading strategies we feature in our swing trade alert service, there were 30,932 trade setups that occurred during a 24-year period. Over the entire period, the profit in backtests far outweighed the losses.

But that doesn’t mean every week would have been like taking money out of an ATM machine. The backtest had many periods with strings of losses. Sometimes there would be months at a time where the backtest reflected a net loss for the trading strategy. Yet clearly over the long term, the strategy was profitable in backtests.

Those losses reflect part of the risk involved with trading. They are considered a drawdown on the account. And ultimately there is no way to be sure how deep a drawdown will go since there is no guarantee about what will happen in the future. That’s part of the risk we take on when we actively trade in the stock market.

Position Sizing Affects Drawdown Amounts

One key way to manage risk is with position sizing. The position sizing approach we used in back tests was sometimes aggressive. It generated solid returns in backtests, but it comes with substantial risk.

You can adjust the amount of risk (and therefore also the potential reward) by adjusting the position size of your trades. If you go with a smaller position size, you are putting less of your money at risk. It’s the reverse if you go with a bigger position size. The bigger the position size, the deeper the potential drawdowns.

Example that Demonstrates How Position Sizing Affects Risk

For one of our options trading strategies, the position size used in backtests was equivalent to 4% of the account balance. The trades for this strategy typically last about a week (five trading days).

If you were to take one trade per day, that means at any given time you might have five trades open. If you have five trades open at once, each risking 4% of your account balance, that means you have could have up to 20% of your account at risk at one time.

If somehow all five positions end up with a full loss (which can indeed happen on occasion according to backtests), that means your account value would go down by 20%.

Of course, backtests of this strategy suggest that over the long haul, you might have more winners than losers and so your account balance might also grow aggressively with that sort of position sizing. But this example demonstrates the risk involved and shows how drawdowns can be a major factor in your trading experience.

If those sorts of drawdowns seem too intense, you can simply dial down the position size (which simultaneously dials down the potential return).

Each person has unique risk preferences. Some people have a big appetite for risk. Some are very cautious. No matter what you prefer, it's totally ok! The key is to honor what works for you.

Each person is responsible for their own trading, and so it is up to you to choose a position sizing approach that corresponds with your own personal risk preferences. You can do paper trading until you get a feel for what position size is optimal for you.

If you have any questions about drawdowns or position sizes, you can reach out to us any time and we’ll be ready to help.

 

FAQs About Drawdowns

Question: Is it possible to blow out an account with your trading strategies?

Answer: Yes it is. You might be using a trading strategy that has a bonafide long term edge, but if your position size is too big, you could potentially blow out an account just from going through a temporary rough patch with the trading strategy.

That’s why it’s important to tailor your position sizing to your own risk preferences. Our stock and options picks might have a strong long-term edge according to backtests, but you have to be able to weather the storm during rough patches (which are inevitable), and position sizing is a mechanism you can use to do that.