Definition: In financial technical analysis, a drawdown is a method used to measure the financial risk of an investment. Simply put, it is the extent or the amount of losses carried by a financial instrument since it starts to decline from a high point until it bounces back to surpass such point.
What Does Drawdown Mean?
This method is commonly used to manage investment’s risks in terms of money and also time. The magnitude (how low the price gets) and the duration (how long a drawdown lasts) are two specific factors that define this metric. Investors usually calculate the time a security spends on recovering to its previous high.
The time–under–water term is also employed to identify how long it took the security to reach the amount of its previous peak. The highest value achieved will be the peak, so any subsequent balance below the peak will be part of the drawdown.
Also, there is a maximum drawdown or Max DD, which is related to the largest difference between the highest and lowest point of the variable involved without subsequent points.
Bankers use this concept slightly differently than investors. For banks, a gradual access to a line of credit is also known as a drawdown. Let’s look at an example.
Charles is an experienced investor. He has been trading in the market for ten years and he has just opened a new account with $50,000. After a few days, he lost $5,000 due to a gradual decline in the price of several of his stocks. Nevertheless, he quickly recovered from this situation and his portfolio grew to $70,000.
Two months later his account went down to $55,000, but it recovered after a few weeks to $75,000. During this later stage, Charles experienced a drawdown of $15,000 ($70,000 – $55,000).
Further analysis of his account’s drawdown might reveal the actual risk profile of its portfolio.