Explainer: Deep dive on drawdowns

Traders get involved with the financial markets because of the potential rewards they can bring. However, on the other side of the coin is the inherent risk.

Any good broker doing a good job should always alert and educate clients on the potential risks that come with trading. You will be aware never to invest more than you can afford to lose for a start. You will be aware of the benefits of employing risk management techniques in your trading, with the goal of extending your capital as far as possible, while booking profits and minimizing your risks. You will also maybe be aware of the power of diversifying your portfolio across sectors, regions and asset classes to weather any storm. But drawdowns may not be common knowledge for all traders. 

Unlike putting your savings into a low-risk savings account, the price of tradable assets can both rise or fall. When buying the underlying asset, you need the price to rise to book profits (unless you are shorting the security). However, with CFD trading, you can trade in both bullish and bearish markets, a major benefit to this trading type.

When buying the underlying asset, you may find that you open up your account to see that you have less equity in there than when you first started. However, history shows us that over time your capital will likely grow at a faster rate than in your bank or savings account. Along the way, you may face ups and downs, but the end goal could be worth it.

Volatility across asset classes

Classically some markets face more bumps than others. For instance, the volatility of certain cryptocurrencies means that overnight, 10% or more of the value of the crypto can be wiped off. Cryptocurrencies are an extreme example of volatility. Commodities, bonds and indices tend to be more robust, while stocks can also take you for a bumpy ride. No matter what asset type you are investing in, the amount your investment drops from its high point to its low point is the drawdown.

And it’s this that any savvy or mainly profitable investor will be prepared for by using risk management mechanisms. If an investor decides to withdraw his money when the asset is at its low, this is called crystallizing your loss. 

But for an investor who keeps his money in the relevant market, he will likely find that the market will eventually recover. An excellent example of this is in 2020, following the pandemic’s start; some stock markets had a third of their value wiped out in a matter of a few weeks. However, after this point, the markets rebounded to enjoy an extremely strong bull market, which led right through to 2021.

The way to understand how a drawdown can affect you is by looking at the charts. If you are looking to trade an asset like the S&P 500, or in fact any stock or asset, study the history of that market to discern what a drawdown looks like. If it looks too scary, then perhaps that particular market does not suit your risk appetite. On top of that, it helps you to be prepared, so you won’t get any nasty shocks.

Historically, equities are the most volatile mainstream asset class – although cryptocurrencies take volatility to a whole new level – while bonds are less volatile.