A Drawdown is a dip in account value from its highest point.

Wikipedia has a very rigorous definition here.

Extra Insight:

An open drawdown is calculated by taking the current market value of both open and closed positions.

Two tricky things about drawdowns:  knowing how much you can handle, and estimating how much you might be in for.  That’s the key to pick a trading system (strategy and sizing) that doesn’t risk more than you can afford to lose.

During backtesting, keeping track of adverse excursions, or how far winning trades go in the wrong direction can give some insight into potential drawdowns of a trading strategy.  

To be absolutely sure to avoid devastating drawdowns its necessary to limit the amount of money in play.

Each person must define what level is devastating for themselves however 50% loss is often called “blowing up”.

Last updated 11/11/08.

Tags: backtesting, drawdown, loss, risk, sizing, system, trading