Drawdown in Trading [Explained]

When we see the collapse of a stock on a trading chart we have to ask ourselves how important this figure is in the future of an investment. Evaluating the Drawdown is fundamental in trading and you have to learn to analyze it scrupulously, but how do you do it?

The steps to follow to analyze a Drawdown can be summarized in these steps:

• You register with a regulated and secure Broker.
• Practice on the Demo account to become familiar with the trading platform.
• Study the historical data of the stocks that interest us and analyze the related drawdowns.

Thanks to online brokers like eToro you can study the drawdowns of many stocks. Here are the best platforms that allow you to carry out this analysis with extreme precision:

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Drawdown, what is that?

The Drawdown is the fall of a price from a maximum to a minimum in a period of time and can concern any market: Stocks, Indices, Forex, Commodities, etc.

It is usually measured as a percentage of the investment, if for example a stock reaches 100 euros and then collapses to 50 euros and then starts to recover, it has marked a drawdown of 50%.

Drawdown is used to measure investment risk. Looking at the history of the stock we are trading, its maximum drawdowns give us an idea of the risk inherent in that particular stock.

Drawdown meaning

Following the example given in the previous paragraph, as long as the price remains below the maximum of 100 Euros, the Drawdown is in progress, once a new maximum is marked, the Drawdown is finished and is recorded as a historical data.

The meaning of Drawdown is very important precisely at a “historical” level because it helps to understand the risk inherent in a given stock or market.

In any forex or stock market trading strategy for example, knowing the maximum drawdown allows you to calculate the theoretical maximum risk of a trade. So, if you want to place a very cautious Stop loss just place it below the low of the forex pair or stock we are looking at.

In the NASDAQ index chart below we can see the 30% drawdown due to the outbreak of the global pandemic in March 2020:

How to analyze a Drawdown

To analyze a Drowdown it is necessary to access the historical charts of the stock we want to trade.

CFD brokers are the ideal solution for this kind of analysis because they provide a trading platform with all the tools and data needed to view forex charts, stock market charts, indices, etc. with high precision.

Choosing the right trading platform for our needs is not easy but we must keep in mind some peculiarities that a safe and reliable online Broker cannot miss:

• Must offer CFDs, contracts that allow you to trade both up and down (short selling)
• You don’t have to charge commissions
• It must have at least one license issued by CONSOB or CySEC

To make a selection, tests must be carried out on the platforms, the services offered, the support and assistance provided by the various CFD brokers.

OnlineTradingCourse.net, which has already carried out these evaluations, believes that the CFD Brokers with the best platforms to analyze historical drawdowns and do online trading are those of eToro, ForexTB and Trade.com. Before continuing our guide let’s see the characteristics of these intermediaries:

eToro: intuitive platform

eToro is the most popular CFD Broker in the world, with over 10 million subscribers. Its trading platform is the most intuitive and allows you to analyze the drawdowns with great speed and precision.

The CONSOB license confirms the reliability and safety of this Broker and below we can see the Drawdown of the NASDAQ (which we took as an example) as it appears on the eToro platform:

To invest on eToro you have to choose the stock you are interested in, click on “Invest”, decide whether to Buy or Sell and how much to bet in the single operation.

If you don’t like “manual” trading but prefer automatic investments, eToro has patented Copy Trading, a system that allows you to copy the market operations of the best investors in the world (chosen directly by the user on eToro), in a totally automated way and at no extra cost.

To exploit the potential of Copy Trading you must follow these steps:

• Register for free on eToro
• In the “People” section, choose the traders to copy, based on how much they earn.
• With a click, Copy Trading will copy the operations of the chosen traders into your account.

At that point you will get the same returns as these trading experts (in proportion to the investment made), at no additional cost.

Your returns depend on the traders you are copying, here are some taken for example:

Both “manual” trading and “automatic” Copy Trading can also be tested on a free Demo account, where there is no risk, because in the Demo the money is virtual.

For more details you can read our full review on eToro.

ForexTB: guide

ForexTB stands out for the free support it has always offered to its investors, moreover the CySEC license, an absolute guarantee of security, allows it to offer its services throughout Europe.

To satisfy the needs of all traders, ForexTB offers two trading platforms that allow you to analyze the drawdowns in a very professional way and are both free:

• Metatrader 4 is a platform with numerous tools available, which meets the needs of the most experienced traders.
• The web platform is simple and accessible from any browser, without making any downloads and below we can see the example of the NASDAQ Drawdown as it appears on this platform:

What made this Broker really famous is the Trading Course that he created and made available for free. It is an ebook that explains the basics of online trading, including the importance of drawdown analysis. To download it for free just follow the link below:

The operational support provided by ForexTB becomes really useful by sending free Trading Signals to all investors. These indications are processed by Trading Central and have a success rate of over 70%.

Read our ForexTB review for more information.

Trade.com: free educational tools

To buy (or sell) the NASDAQ CFD you have to click on Buy (buy) or Sell (sell) and decide how much to invest in the single operation.

The focus on training has always characterized this Broker. Novice traders can rely on a free Trading Course that explains the rules of technical analysis including the importance of measuring drawdowns. The pdf can be downloaded for free, just use the link below:

For the more experienced traders, on the other hand, Trade.com has created advanced video courses, which go to dissect the various trading techniques. To access the video courses for free, just use the official link below:

To open a real account with Trade.com you only need 100 Euros, a figure lower than the competitors’ average, but to get started there is always the totally free and unlimited Demo account.

If you want to know more, you can read our Trade.com review.

Drawdown: information to remember

When analyzing a drawdown it is essential to keep these aspects in mind:

• A drawdown refers to how far an investment or trading account has fallen from a peak to a significant low.
• Drawdowns are usually recorded as a percentage, but other units such as points, dollars or euros can also be used.
• Analyzing Drawdowns means measuring downward volatility.
• The time it takes to recover a drawdown is as important as the data itself.
• A drawdown and a loss are not necessarily the same. A Drawdown measures the distance from a peak to a minimum while a loss occurs only if the operation is closed precisely on that minimum.

Drawdown risk

Drawdowns measure the risk of a given stock and allow you to evaluate an investment with greater awareness.

When a stock, a currency pair, an index or any other asset loses value, more effort is required to recover the previous maximum and this value grows with the increase of the drawdown risk.

For example, a stock that falls by 1% will have to rise by 1.01% to recover the loss. While a drawdown of 50% is quite another thing, in fact a performance greater than 100% is required to return to the previous maximum.

For this reason, calculating the Drawdown risk means evaluating how much you are willing to keep a losing position open and for how long, because a significant collapse requires more time and more effort to recover.

While this may seem obvious, not all stocks recover after a drawdown, indices like the NASDAQ or the Dow Jones show a positive trend that has lasted for decades, but even the US economy could go into recession one day.

Individual stocks (or currency exchange, commodities, etc.) instead react very differently to a drawdown and unlike many stock indices, which usually tend to rise again, it is not certain that they will succeed.

Drawdown trading

Unless you only invest in US indices which have a tendency to recover quickly, the drawdown risk is mitigated with diversification.

Trading strategies must always keep in mind this risk which obviously becomes less dangerous if you do Scalping or Day Trading, as with short-term operations and reduced stop losses, the Drawdown risk is also very low.

If, on the other hand, your investment strategies involve long-term operations that remain open for weeks or months, analyzing the drawdown risk is essential.

To do this, as we have seen, we need an online broker with the historical data of the stock that we have to evaluate, at which point we have to view the chart with a very long timeframe, perhaps weekly or even monthly and look for the worst historical drawdowns to take them into consideration.

Often these collapses are linked to global events such as economic crises (for example the 2008 crisis) and are quite cyclical, but what matters is to calculate the risk, i.e. the extent of this collapse, so as to be able to estimate the future risk of the investment.

Read also: Trailing Stop

Recovering after a Drawdown

While the extent of a collapse is a factor that measures risk, the time it takes to recover can also make a difference.

Not all investments behave in the same way as we have seen, indices are very different from individual stocks for example.

A 10% drawdown of one ETF for example could take years to recover, while another ETF could recover within months.

Analyzing the historical behavior of a stock helps us predict not only the magnitude of the drawdown risk but also the time factor, which is equally relevant when looking for a profit in a financial investment.

Conclusions

Understanding the importance of the Drawdown in trading is fundamental, in this guide we have analyzed what it means, how it is analyzed and what is needed to know this data, to limit the risks when making investments in the markets.

To learn how to calculate the Drawdown it is essential to practice with the trading platforms, better on the Demo accounts that the online brokers make available and which contain the historical data of many stocks.

Here are the official links of the free Demo accounts offered by the best trading platforms:

• Access the eToro Demo account for free by clicking here
• Register on ForexTB and try the Demo account by clicking here
• Access the Trade.com Demo account for free with this link