Introduction:
The stock market is one of the most lucrative places to make quick money. However, you need to have loads of patience, knowledge, and diligence to become a booming stock market investor. As you know, share markets go through upsides and downsides frequently. So, you must know when to enter or exit your investments.
As a rookie investor, you need to understand various terms in stock trading parlance to mitigate risks and maximize profits. ‘Drawdown’ is one such term that can help you analyse the market volatility during a specified period and make prudent investment decisions.
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Continue reading to learn the meaning of ‘drawdown’ and how it can help you during your stock trading journey.
What is a Drawdown?
A ‘Drawdown’ can be defined as the highest possible loss you can incur on your investment value during a specific period. You can measure a drawdown as the difference between the highest peak and the lowest trough in the market value of an asset during a particular trading window. It differs from the actual loss, which you can calculate by subtracting an asset's selling price from the purchase price.
A drawdown evaluates the historical risk associated with an asset (stock, in this case). Understanding drawdown meaning can help you manage market volatility, gauge through turbulent times, and know the maximum loss you can incur in your investment.
Understanding drawdown with the help of an example
Let us take an example to understand the drawdown and how it can help you tweak your investment strategy. Usually, you calculate your investment returns based on a specific time frame, such as a week, a month, or a year. Suppose you have invested Rs. 10 lakhs in an asset which becomes Rs. 15 lakhs after just six months. It means that your annualized returns are 100%.
However, the markets declined soon, and the value of your investment fell to a low of Rs. 8 lakhs. So, as per the drawdown definition, i.e., the difference between the highest peak and the lowest trough during a period, it can be calculated as Rs. (15-8) lakhs, i.e., Rs. 7 lakhs. Thus, the highest loss you could have made had you entered the market at the top-most point and exited at the lowest is Rs. 7 lakhs. As you can see, this amount is not the same as your actual loss of Rs. (10-8) lakhs, i.e., Rs. 2 lakhs.
Importance of Drawdown
Now that you know about the drawdown, we will discuss how it can help you improve your stock trading strategy.
- A drawdown allows you to understand the pattern of probable peaks and troughs before investing in an asset. You can decide the best entry and exit points for your investments with optimum profit margins.
- Knowing a drawdown also gives you an idea of the risk-return ratio for a particular investment. If you are ready to take high risk, you can invest in stocks with higher drawdowns. In contrast, you can invest in stocks with low drawdowns if you want to take a safer approach.
- You can even select a mix of stocks with varying drawdowns to provide optimum diversification to your investment portfolio. A portfolio containing stocks with lower drawdown ratios generally provides modest returns with moderate risks. On the other hand, a portfolio containing stocks with higher drawdown ratios has the potential to give towering returns but with equivalent risks.
- Understanding drawdown can help you ride through turbulent times and achieve your financial goals. At times, the value of your investment can drop drastically due to market volatility, and you may feel a strong urge to exit. However, using the drawdown ratio in such times lets you speculate future price movements and decide accordingly.
- Drawdown symbolizes that a temporary decline in your investment value does not mean you have incurred a loss. You realize a loss only when you exit your investment in red. One of the biggest misconceptions provokes several novice investors to make wrong calls while trading in the market.
To sum it up
A drawdown is a relative measure of the rise and fall of your investment during a specified period. Understanding drawdown can help you make diligent investing decisions and maximize profit margins. It also allows you to overcome fearful sentiments during bearish markets and stay invested to achieve your financial goals.
Try implementing drawdown in your trading game to determine adequate entry and exit points. With Motilal Oswal, you can open a free Demat account and start your stock trading journey today.
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