You should determine exactly what assets should be liquidated or hedged if the securities in your portfolio experience losses that are beyond the tolerance set for an individual period such as a month, quarter or year. Even if your objectives are to produce returns with a long-term bias, the short-term performance volatility matters, especially when there are adverse market conditions. Let's take Alpari's explanation from Donna's link: The relative DD according to point eight.. You can also calculate the maximum drawdown per a period, but many times this is just referred to as the monthly or quarterly drawdown.
What is a 'Maximum Drawdown (MDD)'
The beta describes the volatility of a security and its relationship to a broader measure of risk. The beta can describe systematic risk of a portfolio in comparison to the market.
Beta helps calculate the expected return of a portfolio relative to the expected overall market returns. Another data point that is used to evaluate the historical performance of a portfolio is the length of the maximum drawdown.
The maximum drawdown duration is the longest time between peaks. This could coincide with the largest peak to trough loss, but might not always be the case. You might have a flash crash that generated a maximum drawdown that lasts only a few weeks, which might be larger than the longest period where you experience a drawdown. While many investors are concerned with the maximum drawdown of a portfolio, there is much less attention paid to the maximum drawdown duration.
Many investors believe that the duration of a drawdown is more painful that the magnitude. Many traders place a lot of importance on the maximum drawdown figure. Even if your objectives are to produce returns with a long-term bias, the short-term performance volatility matters, especially when there are adverse market conditions.
This issue is most pertinent when you compare the portfolio you are evaluating to a broader index. When you are trading currencies, you can use an index such as the dollar index as a base for comparison. The maximum drawdown is a handy way of measuring the worst expected scenario of portfolio performance.
One of the benefits of using maximum drawdown is that it does not incorporate additional data points such as the standard deviation or semi-deviation or downside deviation.
A useful risk measurement metric that incorporates maximum drawdown is the Calmar ratio. The ratio is calculated by dividing the annualized growth rate of a portfolio by the maximum drawdown during the same period. To compare two portfolios using the Calmar ratio, you need to compare them over the same period. A drawdown in your portfolio represents a significant risk to investors and recovering from a sharp loss can be difficult.
Experienced traders know that the amount required to recoup a loss will increase dramatically and disproportionately as the loss increases. This is typically referred to as Asymmetrical Leverage. By managing your downside risk, you can better survive the adverse effects to your trading account.
The drawdown in your portfolio will typically be correlated to the level of risk exposure of your trading strategy. If your strategy is systematic, you can base future drawdowns on historical maximum drawdowns.
If you are a relative value trader, who is looking for a currency pair to rebound after a substantial dip, then you should have an idea of how far you would let your trade move against you before you cut your position. Using historical data to determine theoretical past drawdowns is a great way to gauge maximum drawdowns or drawdowns over a certain period. But always remember, that your worst drawdown is yet to come.
The reward that you experience is predicated on the risk you take. If you are using a trend following trading strategy such as a moving average crossover , you should expect that the strategy will lose more than it wins, and, that you will experience prolonged drawdown, until the market begins to enter a trending phase. When you design your trading strategy you need to be cognizant of the types of drawdown you expect to occur, and be willing to accept this drawdown as part of your trading business.
Unfortunately, drawdowns are part of forex trading. Potential reward is inextricably linked to risk, meaning Investors will typically generate returns which are predicated on the level of risk they are willing to assume. The key to managing a drawdown is to have a risk management plan that allows you to survive adverse market conditions. While drawdowns can be calculated manually, most forex analytics systems such myfxbook automatically does this for you.
Drawdown can help traders to identify if a trading system or method is profitable in relation to the risks associated with it. As a trader, drawdown therefore can tell you if you need to change the default contract sizes or if you have to completely overhaul your trading strategy. Drawdowns keep changing if a new peak or a trough is hit and therefore is not a constant but a variable that keeps changing throughout the lifespan of a trading system or a fund.
It is for this reason; one commonly gets to hear the phrase that past performance is not indicative of future results. As a general thumbrule, the lower the risk per trade the lower the drawdown will be but at the cost that growth or profit increases at a very slow pace.
On the contrary, more risk you take, higher the forex drawdown and the profits will be. The goal therefore for most traders or fund managers is to find a balance between risk and growth and this is where drawdowns are most helpful.
Think of this as the disaster prevention plan for your trading business. What would happen if you lost 20 trades in a row? Think about that for a moment. Take the percentage you have been risking per trade and multiply it by 20 and see what you get.
And if you trade long enough, you will experience at least one that is quite severe. Nobody knows what will happen tomorrow, much less several months from now. It comes down to your tolerance for risk, which only you can determine.
But again, it depends on your tolerance for risk. The second step in this process is to lower your risk per trade if losses continue. The first is to continue risking the same amount per trade.
Option number two is the worst offender. Instead of maintaining the same level of risk as losses pile up, they try to make back what was lost by increasing their risk. The third—and best—option is to reduce your risk per trade with each subsequent loss. This guarantees you a soft landing during a drawdown period, rather than a crash and burn experience.
Once you regain your confidence, you can start increasing the risk per trade back to its original level. This usually occurs after two to four winning trades. Some months it will feel like the entire market is against you.
Just like you set your risk per trade, you can establish a drawdown cap. I mean, what if you hit that within the second week of the month? Of course, you can always modify a rule like this to better fit your style.
Instead of waiting until the next month to begin, you could make it the next week. Either way, this type of rule is incredibly powerful. Not only does it help you avoid the crash and burn scenario, but it also forces you to be more selective about the setups you pursue.