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We can meet the term “drawdown” in both sectors: in banking and in trading. Nevertheless, the meaning is not the same. On the one hand, a drawdown means a reduction in equity when used in trading. On the other hand, the banking sector uses the term to explain a gradual accessing of credit funds.
The gradual accessing of the whole credit line or of its part (both for personal or business arrangements) is referred to as a drawdown. To illustrate the example of an individual borrower, let’s imagine a homeowner who needs a credit line for performing a major home renovation. Typically, not all the works are done at once. That is why the borrower only draws down as much as needed from the credit line. It is crucial that the individual withdraws the funds only as he needs them since this strategy allows them to keep the minimal debt: they only pay the interest on the borrowed funds that are actually put to use.
On the other hand, if the borrower decides to take out the whole amount at once, this would be considered inefficient management of capital. The individual would be paying unnecessary interest charges before they know the actual amount that is needed for the home improvements.
When it comes to the business point of view, the case can be represented with a similar example. This time the borrower would be a construction company that is approved for financing a housing development. The company also decided to withdraw the financing funds gradually, taking into account each completed portion of the project. Such arrangements can be limited by time or project completion restrictions from the lender. To show an example of a time restriction, the borrower can access a certain part of the funds every three months. As for a project completion restriction, the lender can demand from the borrower to show that the previous stage of the project was successfully completed before the borrower would be eligible for receiving more financing.
To switch to the trading dimension, we can look at a drawdown as a decline from a peak to a pullback low of a specific investment or equity in a trader’s account. Yet to describe a drawdown more accurately, it is usually considered a movement from a peak high to a trough low and again to a new peak high. There is a reason for such a way of measurement: troughs cannot be identified unless a new peak high is achieved, or we can see a return to the original level.
The phenomenon of drawdowns is often used by commodity trading advisors: this approach helps them determine the risk of financial investments. Moreover, they can be examined by magnitude (amount of money) and duration (period).
Drawdown magnitude describes the amount of money lost by the investor during the period of a drawdown. In terms of equity, the drawdown amount is expressed in percentages. Drawdown duration tells us the duration of time it takes an account to get back to peak level after a trough. Drawdowns happen in overall profitable trading accounts, as well.
Are you trading in highly leveraged instruments like futures contracts or forex? Potential drawdownS are crucial to take into account then. If you need any assistance with that, contact our specialists in COREDO.