Drawdown in Banking vs. Drawdown in Trading: An Overview
The term "drawdown" appears in both the banking world and the trading world, but it has very different meanings within each context. In banking, a drawdown refers to a gradual accessing of credit funds, while in trading, a drawdown refers to a reduction in equity.
- In banking, a drawdown refers to a gradual accessing of credit funds.
- In trading, a drawdown refers to a reduction in equity.
- Drawdown magnitude refers to the amount of money, or equity, that a trader loses during the drawdown period.
Drawdown in Banking
An example of the use of drawdown for an individual borrower is a homeowner who applies for a line of credit with a bank, intending to make major home improvements. Since he does not plan to do all of the work at once, it is to the borrower's advantage to only draw down funds as needed from the line of credit that the bank extends to him. By only withdrawing funds as needed, the individual keeps his level of debt at a minimum and is only paying interest on the borrowed funds that he has actually used. It would be inefficient management of capital, costing the borrower unnecessary interest charges, for him to borrow the total amount all at once, thus incurring the maximum level of indebtedness before he knows the actual amount he needs to complete the proposed improvements or before he needs the money.
A lender and a business may make a similar arrangement. For example, a construction company may be approved for financing to build a housing development, but it only gradually accesses the financing funds as it completes portions of the project. The lender may put time or project completion restrictions on such an arrangement. An example of a time restriction would be a stipulation that the borrower can only access a certain percentage of the funds every three months. Project completion restrictions would require the borrower to show completion of a specified amount of the total project before releasing additional financing.
Drawdown in Trading
In reference to trading, a drawdown refers to a drop in equity in a trader's account. A drawdown is commonly defined as the decline from a high peak to a pullback low of a specific investment or of the equity in a trader's account. However, a drawdown is more accurately looked at from a peak high to a trough low to a new peak high. The reason for this method of measurement is that troughs cannot be absolutely identified until either a new peak high is reached or a return to the original high.
Commodity trading advisors often use drawdowns to determine the risk a financial investment faces and can examine it from two different angles—either by an amount of money (magnitude) or a period (duration).
Drawdown magnitude refers to the amount of money, or equity, that a trader loses during the drawdown period. The amount of drawdown is expressed, regarding equity, as a percentage. It's calculated from the peak in the account's equity to the trough low. If a trader begins an account with $40,000 and then loses $4,000, the trader has experienced a 10% drawdown.
There can be drawdown even in a trading account that is profitable overall. Assume a trader who deposited $10,000 built the account up to $20,000, but then suffered a series of losses that brought the account balance down to $15,000. Even though the trader would have a 50% profit on his starting capital, he would still be recognized as having suffered a 25% drawdown from the peak level of $20,000.
Drawdown duration refers to the period required for a trader to raise an account back to its peak level after a loss. If the trader who experienced a 10% drawdown when his $40,000 account dropped $4,000 to a level of $36,000 took two months to return the account to $40,000, then the trader would have experienced a two-month drawdown.
Potential drawdown is an especially important consideration when trading in highly leveraged instruments, such as forex or futures contracts.
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