Drawdown

Drawdown is simply the amount of money you lose trading, expressed as a percentage of your total trading equity. If all your trades were profitable, you would never experience a drawdown. Drawdown does not measure overall performance, only the money lost while achieving that performance. Its calculation begins only with a losing trade and continues as long as the account hits new equity lows.

Suppose you begin with an account of 10,000 and lose 2,000. Your drawdown would be 20%. On the 8,000 that remains, if you subsequently make 1,000, then lose 2,000, you now have a drawdown of 30% (8,000 + 1,000 - 2,000 = 7,000, a 30% loss on the original equity stake of 10,000). But, if you made 4,000 after the initial 2,000 loss (increasing your account equity to 12,000), then lost another 3,000, your drawdown would be 25% (12,000 - 3,000 = 9,000, a 25% drop from the new equity high of 12,000).

Drawdown recovery The best illustration of the importance of money management is the percent gain necessary to recover from a drawdown. Many think that if you lose 10% of your money all you have to do is make a 10% gain to recoup your loss. Unfortunately, this is not true.

Suppose you start with 10,000 and lose 10% (1,000), which leaves you with 9,000. To get back to breakeven, you would need to make a return of 11.11% on this new account balance, not 10% (10% of 9,000 is only 900--you have to make 11.11% on the 9,000 to recoup the 1,000 lost).

Even worse is that as the drawdowns deepen, the recovery percentage begins to grow geometrically. For example, a 50% loss requires a 100% return just to get back to break even (see Table ).

As losses (draw down) increase, the percent gain necessary to recover to breakeven increases at a much faster rate.