Welcome to VRD nation. Through this channel, we are trying to build a community of investors and traders, where anyone, who is getting started with the stock market or getting started with trading or investing can come and easily understand even the most difficult topics in the simplest way.

That is the reason why we use animations, real life examples and real life case studies. If you are new to this channel, do not forget to subscribe.

One of the things that we do differently in this channel is that we not only talk about profits, but we also like to talk about losses because it is my philosophy that in trading, you have to take care of losses, because if you can take care of your losses, the profits will take care of themselves.

Today’s topic goes perfectly with that theme. Without any further ado, let us get started. The topic at hand today is draw down, which basically means the percentage of capital a trader loses before bouncing back.

Let’s take an example to understand this. Assume that you were doing great in your trading and the capital in your account was growing nicely and life was good. Then you hit a rough patch and started to take some big losses and your strategy stopped working as well as it used to. Either way the losses start to eat into your capital and the account value starts to come down. In this case, the maximum value of the account from where you started to see the decline would be called the peak and the lowest point from which you recovered back would be called the trough and the percentage difference between the two is called drawdown.

Note that Drawdown in trading is very common. Every trader, including myself, has gone through drawdowns. It is very normal and hence happens all the time. The percentage of drawdown is what is very important to understand. A 10 to 20% drawdown is very common and it happens all the time.

However, a deeper drawdown of 40% or 50% could be very damaging to the account, because as you can see from this table, the deeper the drawdown, the harder it becomes to get back to normal. If your drawdown is 50%, then now you need to make 100% of gains just to go back to the point where you originally were.

Again, as you can see from this table, the math can turn ugly from this point onward. Now let us look at what causes drawdowns. In my experience, there are 3 common reasons why this usually happens. The first and the most common reason is that traders take big losses that wipe out most of their previous profits.

Sometimes a few trades, one day of bad trades or even one bad trade can wipe out a significant amount of capital.

The second possibility is that the trader is experimenting with some new strategy or trying out some new instruments. It is also possible that since he or she has mastered this strategy or instrument, they are experiencing a drawdown.

For example, in my case, I used to actively trade in Bank Nifty Futures before I shifted to Nifty Options. My transition from Bank Nifty to Nifty and from Futures to Options, took a lot of time and during that period, I experienced some drawdown, which is very normal to expect.

The third possible reason for a drawdown is that the market conditions may have changed and so the strategies that used to work earlier may not be working in this market condition. For example, in 2021, when the market was extremely bullish, traders were making easy money by just buying the dips.

Every time you bought a dip, you made 5% or 10%. However, if  you deploy the same strategy in 2022, you would have a tough time making money. Hence the market conditions change and that can also induce some drawdowns. I can tell you from my experience that drawdowns can be very stressful and induce all sorts of emotions in us.

We lose confidence, start to question ourselves and start to take trades out of desperation. What I have seen is that these negative feelings tend to cause the drawdowns to become even more severe than they really have to. Hence what I have learned is that during these periods of drawdown, detach yourselves from the situation and look at it like a doctor who would look at the patient. There is nothing personal about it. Understand that it is a problem and you have to diagnose the problem. Find the root cause and fix it. So far we have talked about the reasons for  drawdown and its effects.

Let us now talk about a powerful way of looking at drawdowns more proactively, and this can be done through back-testing. When you back-test a strategy through platforms such as Amibroker, Trading view or Python, the application shows you the maximum drawdown for the strategy, meaning, that if you use that strategy, how much your account value can come down from its peak. I put a great deal of emphasis on this because it doesn’t matter how good the strategy is.

The maximum drawdown is 30% or 40% or even more. It is a deal breaker for me because it will become that much harder for me to get back to where I was at my peak. I hope that you understood the concept of drawdowns and you would apply that in your own trading journey.