What is a drawdown? Video 1 Transcript
Whatever the underlying trend might be, market prices inevitably show peaks and valleys. A drawdown is the total change in price from one peak to the next valley. It represents the largest loss potential that a trader could experience within a trading horizon, assuming buying and selling at the least opportune moments in the cycle.
A trader whose trade horizon is a matter of days or weeks would evaluate the drawdown potential looking at short term cycles. A trader whose horizon ran into months could look at longer term price patterns to identify meaningful drawdown potential for his or her trades.
Drawdowns can be used to analyze patterns of actual trade performance in order to identify the risk-and-reward relationship of trade activity.
Some traders look back over the results of a strategy for some period and then calculate their actual net returns for the period. Then they chart the price action for the same period and calculate the maximum drawdown that they subjected themselves to in order to see whether the profits earned justified the risks taken.
Other traders use a drawdown concept to set a daily loss limit. They establish a target maximum allowable loss, and if they reach that target during the day, they end their activities at that point.
Just as in other forms of financial analysis, ratios play a key role in creating standardized statistics for comparisons and benchmarking of portfolio performance. One often-cited ratio for portfolio performance analytics is called the Calmar ratio, which shows how much return a portfolio has earned for each unit of drawdown risk that the manager assumed.
Here is how a Calmar ratio can be calculated for an investment with a transparent performance track record — in this example, the price action of the S&P 500®.
Take the annualized return of the investment over the target period. In this example, let’s use 11.8%. Then divide that amount by the maximum drawdown experienced by the portfolio during that time. Let’s use 7%. The result is the Calmar ratio. The larger the final number, the better the risk-adjusted performance of the investment.
Keep in mind return and drawdown behavior of any investment can change at any time. That is why professionals use a wide range of risk measurements and analytic tools simultaneously. And they are prepared to respond as soon as their measures show that market dynamics have changed.
Why analyze drawdown? Video 2 Transcript
Drawdown is an investor’s incremental downside risk, the largest cyclical loss that could have been suffered in the course of a particular interval of price action. You can use the drawdown concept to set your own risk limits. You can also use it to assess the results you’ve achieved from your own activities. And you can use it to analyze the performance of professionally managed portfolios.
Let’s take a closer look.
You should always know what your unbooked gain or unrealized loss position is throughout the trading day. That unrealized loss is your daily drawdown. How you set your drawdown limit is not relevant here, but once you do have it, you should have the discipline to observe it. In other words, when drawdown hits your risk limit it is time to take appropriate action.
If you want to assess the results of your activities, track the entire daily profit and loss of your trading activity.
Use your net position change over your study period to calculate an annualized total return. Then follow the ups and downs of your strategy to identify the largest actual loss. Divide the absolute value of the loss percentage into the annualized return percentage and do the same calculation for your benchmark. Whichever produces the higher net number is the one that generated the best risk adjusted return.
Want to use the same principles to evaluate a professional portfolio manager?
Perform the same calculation on that manager’s portfolio returns and make the same comparison. The result that produces the higher number generated the best risk adjusted return.
Remember, past performance does not guarantee future results. But some experts believe that careful analysis of the past can help identify clues to the relative value of different strategies in the future.
