Drawdowns: how a trend-following system deals with risk

Drawdowns: how a trend-following system deals with risk

Every investor wants to know how much a strategy might return. An equally important question is how deep its losses can go. That is what a drawdown measures: the decline of a portfolio from a peak to the trough that follows, expressed as a percentage. In crypto markets, where prices can move sharply, drawdown is one of the most important measures of risk. This article explains why deep drawdowns do so much damage and how a trend-following system tries to limit them.

The uncomfortable arithmetic of loss

Losses and recoveries are not symmetrical. A 10 percent loss needs a gain of about 11 percent to get back to where you started. That looks manageable, but the numbers escalate quickly. After a 25 percent fall, a recovery of more than 33 percent is needed. After a 50 percent loss, the portfolio has to double: an investment that drops from 100 euro to 50 euro must rise 100 percent just to return to 100 euro. An 80 percent loss requires the remaining capital to grow fivefold. This is not a market forecast but simple arithmetic, and it is exactly why asset managers take deep drawdowns so seriously.

There is a human side as well. Deep drawdowns can last a long time and put investors under pressure to sell at the worst possible moment. A shallower drawdown also makes it easier for investors to stay with their strategy.

Why managers watch drawdowns

Volatility describes how much prices fluctuate. A drawdown answers a different question: how much was lost at the worst point along the way. For most investors that second question matters more, because it determines whether a setback can be borne, financially and psychologically. Maximum drawdown, the deepest decline within a given period, is therefore a standard measure of risk. How risk per position is limited in advance is covered in our article on risk management.

How a trend-following system reduces exposure

A trend-following system uses predetermined rules to measure the direction of the market. While the trend points upwards, the portfolio stays invested. When the trend breaks, the system reduces its exposure: positions are scaled back or temporarily wound down. If the trend later recovers, exposure is rebuilt step by step. The system does not need to make a forecast; it responds to what the market is actually doing. That allows it to cut exposure while a prolonged decline is still under way, rather than riding it all the way to the bottom.

What trend following cannot do

To be clear: trend following does not prevent losses. By definition the system reacts after the fact, so the first part of any decline is always felt. It also generates false signals: the market dips briefly below the trend threshold, the system reduces exposure, and then the rise resumes. These whipsaws cost return. A sudden, very sharp fall can also move faster than the rules can respond. The aim of trend following is therefore not to rule out losses but to try to limit how deep they go. The arithmetic above explains why limiting drawdowns can matter so much.

The same rules in a falling market

A systematic strategy goes through declines like any other, and that is when fixed rules matter most. At Callisto Capital the rules stay the same in such periods: the system reduces exposure within limits set in advance, and the rules are not overridden along the way.

Callisto Capital is a Dutch fund for joint account; its manager is registered with the AFM under the AIFMD-light regime and is not subject to ongoing supervision. Participation is open from an investment of 100,000 euro. This article is for information only and does not constitute investment advice.