How to Calculate Drawdown

Drawdown is the measurement of a portfolio of stocks between highs and lows, particularly major highs and lows over extended periods of time rather than day-to-day movements. Measurements may be made through arithmetic, comparative or statistical means. The use of drawdown is an important measure of risk.

Copy the closing values of the portfolio value for each day. Mark major high and low values over time. Take the most recent high and find the following recent low. Subtract the difference. Divide the difference by the high value. The result is the drawdown. Work back in time to construct other drawdowns.

Group the stocks in the portfolio by type; say all the stocks are in the S&P 500. Subtract the performance of the index you use from the performance of your basket of stocks. Consider this drawdown as a measure of relative performance.

Construct the Sharpe ratio, considered a "reward-to-variability ratio," for comparing different kinds of securities like stocks and commodities over different time frames. Sharpe ratios convert performance data to standard deviations and measure their relative difference. Take the actual performance and subtract the risk-free rate of the 10-year U.S. Treasury bond. Divide the difference by the standard deviation of the portfolio.

Use VaR or value at risk for the most popular calculation of expected future drawdown. Compute VaR by taking the value of the portfolio after a four standard deviation decline of value. This means a 1-in-20 chance of probability. Use VaR to measure worst-case drawdowns. Know that worse consequences, called "outliers," could happen. Know that VaR does not predict but calculates the value were such an event to occur.

Calculate recent drawdowns for several stock groups related to the same index. Use these results to buy stocks going forward. Take the stocks that performed best in each group and test the drawdown result. Buy those stocks if the results are acceptable from a risk-and-reward basis.