The Mathematical Problem of Drawdowns

03/02/2022 08:08 AM By Matt Ratliff

Drawdowns are an inevitable part of investing, check out this quick video explaining the math behind drawdowns and recoveries.  After viewing the short video, use the comment section below to ask questions or add a comment.

What is a drawdown?

When your trading account balance gets smaller - you are in a drawdown.  Drawdowns can happen at any time and can last for an indefinite period of time.

Can I avoid a drawdown

Everyone asks this question and everyone doesn't like the answer.  Essentially, if you trade for any period of time, you will most certainly experience drawdowns.  

Here is the math.

You have a trading account balance this morning of $50K.  All day your trades go badly leaving you with a new balance of $25K - a drawdown.

So, with the new balance, how much gain will you need to return to the original balance?  The answer is easy, $25K.  So you lost 50% but will have to grow 100% (double) to return to a balance of $50K.

Why is this a problem?

The problem is- how long it will take to recover the amount of the drawdown.  If you normally get a 12% return, how long will it take to recover the $25K lost, with a $50K account?  It would take just over 6 years.  I suspect you can find examples in your trading history.

Is there a solution?

There are traditional methods to limit drawdowns:  use limit orders, avoid margin calls and diversify.  Here are a couple more:  reduce  your exposure to overnight price swings and limit correlation.  Talk to us if you want to explore this topic more.