ETF Complete Strategy Insights: Drawdowns (Part 1)

James Kimball | September 4, 2019

The ETF Complete model closed the week up +0.8% compared to the SPY which closed up +2.7%.

The SPY closed higher on the week, though only returning to the upper-end of its trading range for the last few weeks. U.S. markets are closed on Monday for the Labor Day holiday.

Stay tuned for the daily updates and log into the website to see holdings and additional performance data.


This Week's Strategy Lesson: Drawdowns (Part 1)


In any instrument where the price fluctuates, drawdowns are inevitable. But not all drawdowns are the same. Some are small and relatively painless while others can shake you out of trades or even the market. In this series, we will explore a few different aspects about drawdowns and look at how they play out in the ETF models.

What is a Drawdown?

A drawdown occurs when your equity goes from putting in a new high to moving off of those highs. Ultimately, we cannot know what the maximum of any drawdown is until the equity proceeds to put in a brand new high. It can be very helpful to look at an illustration.


In the example above, the equity puts in a new “peak” high at $1,200 in July. Over the next couple of months, the equity sells off down to about $1,050. This happens to be the lowest it sells off to before it puts in a new high a year later, but we cannot declare that low as the maximum “peak-to-trough” drawdown until we see it put in that new high. The time to recovery is simply the length of time between when the equity puts in a peak high and then finally puts in a new high.

The frequency and severity of drawdowns can play a big role in how hard or easy it is to stick with a trading system. Frequent, deep drawdowns can test your resolve to stick with a longer-run winning system. Expectations also play a roll. If you go into a trade expecting a particular or high level of volatility, you can adjust your risk and position-size accordingly and stay with the plan.

Drawdowns aren’t just an issue in a bear market, they can show up just as frequently in bull markets. Even in a positive year there can be many small drawdowns. Drawdowns from equity gains and new highs can be just as unpleasant when you are in one, especially if you just started trading prior to a drawdown.


Many times, drawdowns are illustrated with a special type of chart (lower blue-line portion above). This chart plots the difference between the current price and the prior recent or all-time high in percentage terms. If a stock is trading at $45 and had a recent high of $50, the blue line would show a negative 10% value.

Typical drawdown charts don’t show the overall positive or negative change in equity value—and it can often be hard to determine or even guess that value just by looking at a drawdown chart.

In the chart above, we included the equity in orange above the drawdown portion of the chart. We made the percentage scaling for the upper and lower portions of the chart different as well as adding some black lines on the equity to help illustrate some of the drawdowns.

If a trader had a rule that they would stop trading a system after a 5% or 10% drawdown, they would have hit either of those levels, been stopped out, and could have missed out on the next leg up. It isn’t that you should ignore drawdowns or “never sell,” its more about setting expectations and trading guidelines that are appropriate to what you are trading.

If you want to trade say the Sector Moderate model, there is a certain amount of volatility that goes along with that and you should position-size so that the normal volatility of the model won’t force you out.

Next week we will expand on this analysis and look at the drawdown profile for a number of other instruments and models.