Absolute and relative drawdown are key metrics used to evaluate the performance and risk of trading accounts or strategies. While both measure losses, they differ in their definitions, calculations, and implications for risk management.

Understanding Absolute Drawdown

Absolute drawdown refers to the difference between the initial deposit in an account and the lowest point the account balance has reached. It measures the largest monetary loss from the initial deposit, regardless of subsequent profits.

For example:

• Initial deposit: £10,000
• Lowest balance: £8,000
• Absolute drawdown = £10,000 – £8,000 = £2,000

Absolute drawdown is useful for understanding the worst-case scenario in terms of initial capital loss. It does not account for gains made during trading, making it a static measure of risk.

Understanding Relative Drawdown

Relative drawdown represents the maximum percentage loss relative to the highest balance (equity peak) achieved during trading. It reflects the largest drop in equity as a percentage of the highest account balance.

For example:

• Equity peak: £20,000
• Lowest equity: £15,000
• Relative drawdown = ((£20,000 – £15,000) / £20,000) × 100 = 25%

Relative drawdown is dynamic and adjusts as the account grows. It provides a clearer picture of how much risk the trading strategy exposes to profits gained, making it particularly useful for evaluating performance over time.

Key Differences Between Absolute and Relative Drawdown

Aspect	Absolute Drawdown	Relative Drawdown
Definition	Largest loss from the initial deposit.	Largest percentage loss from the equity peak.
Calculation Basis	Based on initial deposit only.	Based on highest balance achieved.
Dynamic/Static	Static measure.	Dynamic and adjusts with account growth.
Risk Implication	Highlights initial capital risk.	Reflects risk to account growth/profits.
Use Case	Evaluating worst-case scenario for initial capital.	Assessing strategy risk over time.

Common Challenges with Drawdown Metrics

1. Misinterpretation of Risk: Focusing only on absolute drawdown may underestimate risks in a growing account.
2. Overlooking Long-Term Impact: Ignoring relative drawdown can hide vulnerabilities in strategies that generate high equity peaks.
3. Lack of Context: Drawdown metrics need to be compared to overall account performance and market conditions for meaningful insights.

Step-by-Step Solutions to Use Drawdown Effectively

1. Track Both Metrics: Monitor absolute drawdown to understand initial capital risk and relative drawdown to assess ongoing strategy performance.
2. Set Risk Tolerances: Define acceptable levels for both absolute and relative drawdowns based on your risk appetite and strategy goals.
3. Evaluate Performance Regularly: Compare drawdown metrics against profits to determine whether the risk-reward ratio is favourable.
4. Incorporate Risk Management: Use stop-loss orders, position sizing, and diversification to minimise drawdowns.

Practical and Actionable Advice

• Define a Drawdown Limit: For example, limit absolute drawdown to 10% of your initial capital and relative drawdown to 20% of equity peaks.
• Use Performance Benchmarks: Compare drawdown metrics with benchmarks like the Sharpe ratio to assess overall strategy efficiency.
• Analyse Historical Data: Evaluate historical drawdown data to identify patterns and adjust strategies accordingly.
• Monitor Real-Time Risk: Use trading platforms that provide live drawdown tracking for better risk control.

FAQs

What is drawdown in trading?
Drawdown is the reduction in an account balance or equity from its peak value, often used to measure trading risk.

Why is absolute drawdown important?
It highlights the maximum potential loss of initial capital, helping traders understand their worst-case scenario.

What does relative drawdown indicate?
Relative drawdown shows the largest percentage loss relative to the account’s equity peak, reflecting risk to profits.

Can absolute and relative drawdowns be the same?
Yes, they are the same if the account has not grown beyond the initial deposit.

Which is better for evaluating performance?
Relative drawdown is more informative for evaluating ongoing performance, especially in accounts with significant growth.

How do you calculate drawdown?
For absolute: Initial deposit – lowest balance. For relative: (Equity peak – lowest equity) / equity peak × 100.

What is a good drawdown percentage?
A good drawdown percentage depends on your risk tolerance but typically ranges between 5-20% for most traders.

How does drawdown affect trading decisions?
Large drawdowns can signal excessive risk, prompting traders to revise strategies or position sizes.

Can drawdowns be eliminated?
Drawdowns are inevitable in trading, but risk management can reduce their size and frequency.

Why do drawdowns vary across strategies?
Different strategies have varying risk-reward profiles, affecting the size and frequency of drawdowns.

Conclusion

Understanding the difference between absolute and relative drawdown is essential for effective risk management and strategy evaluation. While absolute drawdown focuses on initial capital risk, relative drawdown assesses the risk to profits over time. By monitoring and managing both metrics, traders can optimise their performance and build sustainable trading strategies. Unlock your full potential with our expert-led trading courses. Gain insights, learn winning strategies, and take control of your trading journey today.