What Is a Drawdown? (And How to Manage It)

A drawdown is the percentage of your trading account lost from its peak. For example, if you start with $10,000 and lose $3,000, that’s a 30% drawdown.

Psychologically, loss aversion can deepen drawdowns by causing traders to hold losing trades too long, hoping they’ll turn around. To avoid this, use money management and set clear drawdown limits and stick to them.

What Is a Drawdown?

A drawdown is the percentage of your capital that you’ve lost from your highest point (your “peak”) to a lower point (“trough”). It’s a way of measuring how much of your account has decreased over a certain period. For example, if your peak amount of capital was £10,000 and you’ve lost £3,000, that’s a 30% drawdown.

Drawdowns can come from both realised losses (where you’ve closed a losing position) and unrealised or “paper” losses (where you haven’t closed the trade, but it’s currently in the red). We have to manage drawdowns because letting them get out of control can have serious consequences on your account, possibly even wiping it out.

The bigger the drawdown the more difficult it will be to make it back. For example, this table shows what percentage return you need to make to recover from a drawdown:

How Drawdowns Can Spiral

Loss aversion, part of prospect theory introduced by psychologists Daniel Kahneman and Amos Tversky, is a powerful driver in trading behaviour. The concept is simple: people feel the pain of a loss more intensely than they feel the joy of an equivalent gain. 

Because of this, traders often avoid closing a losing trade, even when it might be best to cut their losses. Instead, they may hold on in the hope that the trade will eventually turn positive, risking even greater losses.

One study even found that people tend to take more risks when they’re already facing a loss, rather than accepting the defeat and moving on. This approach often backfires, leading to even bigger losses. 

Managing Drawdowns with Money Management

Having good money management is the first defence against big drawdowns. Here are some general guidelines for keeping your risk in check:

• Limit Your Risk Per Trade: Avoid risking more than 1-2% of your total account balance on any single trade. By keeping your risk small, you can absorb a few losses without a significant impact on your overall account.

• Dynamic Risk: Some trades or opportunities may be riskier than others. In these cases, it might make sense to risk even less, perhaps only 0.5% of your account for weaker trades. That way, trades which are likely to lose more oftenwill add less to your drawdown.

• Use Stop Losses:  Avoid holding onto losing positions indefinitely, this can lead to what’s known as “loss aversion,” where you take on more risk simply to avoid realising a loss.

Setting Personal Rules for Drawdown

To avoid letting drawdowns spiral out of control, set specific rules that align with your own comfort with risk. A maximum drawdown limit can help you maintain discipline and avoid risking more than you can afford to lose.

For example:

• Set a Maximum Drawdown: Set your maximum drawdown at 10% of your total capital, only going up to 15% in challenging times. When you hit the cap, you may need to re-evaluate and optimise your approach, or take a break.
  
  
• Adjust Your Position Size: If you keep hitting your maximum drawdown level, it might be time to adjust your position sizes, risk-per-trade percentage, or even return to a demo account to fine-tune your strategy.

Drawdown Limits for Different Trading Styles

Your ideal drawdown limit may vary depending on your trading style. Here’s a general guide:

• Active, Short-Term Trading: Because price movements are shallower in the short term, traders often use a smaller drawdown percentage, keeping it in the single digits to avoid excessive losses.
  
  
• Long-Term Investing: With longer time horizons, you may be willing to tolerate higher drawdowns, such as 20% or more, especially if you’re investing in assets like stocks that can fluctuate significantly before recovering.

In fact, research on “myopic loss aversion” (Richard Thaler) suggests that the more frequently you check your investments, the more risk-averse you might become, reacting to short-term losses even if they’re insignificant in the big picture.

Final Thoughts: Don’t Let Fear Control Your Trades

We trade based on probabilities, so drawdowns are inevitable. However, we need to make sure we’re managing them correctly. Don’t let the fear of losses drive you into a deep drawdown.

By managing risk and setting drawdown limits, you can protect your capital and build a solid foundation for managing them. Remember, it’s not just about how much money you make, it’s about how much you keep.