Drawdown is the peak-to-trough decline during a specific record period of an investment or investment strategy. A drawdown is usually quoted as the percentage between the peak and the trough. Drawdowns help determine an investment's financial risk.
A drawdown is measured from the time a retrenchment begins to when a new high is reached. This method is used because a valley can't be measured until a new high occurs. Once the new high is reached, the percentage change from the old high to the smallest trough is recorded.
Drawdown is one of the most important statistics when evaluating an automated trading strategy. If the strategy makes £1 million a year from a £1 million trading account, but the model has a maximum drawdown potential of £1 million, there will be no account left to be able to recoup the losses.
The drawdown needs to be viewed in the context of a range of other performance statistics including the average win, the duration of the drawdown and the ease with which the model is able to recoup its losses after the drawdown has occurred.
The trader's risk profile has a large bearing on the tolerability of a drawdown's size and duration. Somebody managing a sizeable pot of capital with a very long term view will see drawdowns and their duration in a very different context to somebody who effectively lives off their trading profits.