Drawdowns are a loss of capital after a series of losing trades. They are calculated using equity curve peaks and troughs. New equity curve highs will reset them. You can calculate them as dollar amounts and/or percentages. Both come in handy and are essential to monitoring a trading system. Some rules of thumb for maximum drawdowns are 50% of equity or 50% of best yearly performance. The other important component is the time it takes to recoup a drawdown. This is measured from peak to new peak. Whether you are a trader or an investor, drawdowns are inevitable. When one does occur, it's important to put the percentage and days into context. Is the current percentage within the range of previous years? Or is it the biggest one for your trading system? Is it near the maximum allowed? Is the length of the drawdown within the range of previous years? Or is it currently the longest one for your trading system?
The reason I'm writing this article is because my 3-tiered trading system recently went through a larger than normal drawdown. My conservative fund dipped 12.93%, my moderate fund dipped 13.23%, and my aggressive fund dipped 12.50%. This system has been trading in simulation since January 2019 and these dips were the systems’ largest to date. Was this the start of a trading system failure? Should I lose faith in it and stop trading? That's where the statistics come in handy. Even though they were experiencing their largest declines, they didn't check one of two boxes for maximum drawdowns. First, did it reach 50% of equity? No. Second, did it reach 50% of best yearly performance? I had to look back to 2019 and the answer was no. The 2019 returns were 57.61% for the conservative fund, 60.25% for the moderate fund, and 54.17% for the aggressive fund. The drawdown levels to watch would be 28.81%, 30.13%, and 27.09%, respectively. Luckily, I stuck with my system and all 3 funds recently made new equity curve highs. BTW, all are also in the top 10% of all funds traded at Collective2.
The use of drawdown statistics can help prevent you from pulling your invested money too soon or from you losing faith in your own trading system. Remember that next time you find yourself in a drawdown as either a trader or an investor.