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Drawdown measures an investment or trading account's decline from the peak before it recovers back to that peak. It remains in effect as long as the price remains below the peak. In the example above, the drawdown is only 10% until the account moves back above $10,000. Once the account moves back above $10,000, then the drawdown is recorded.

This method of recording drawdowns is useful because a trough can't be measured until a new peak occurs. As long as the price or value remains below the old peak, a lower trough could occur, which would increase the drawdown amount.

Drawdowns help determine an investment's financial risk

A drawdown can refer to the negative half of the distribution of returns of a stock’s price; i.e., the change from a share price’s peak to its trough is often considered its drawdown amount. For example, if a stock drops from $100 to $50 and then rallies back to $100.01 or above, then the drawdown is $50 or 50% from the peak.

Drawdowns present a significant risk to investors when considering the uptick in share price needed to overcome a drawdown.

For example, it may not seem like much if a stock loses 1%, as it only needs an increase of 1.01% to recover to its previous peak. But a drawdown of 20% requires a 25% return to reach the old peak. A 50% drawdown, seen during the 2008 to 2009 Great Recession, requires a whopping 100% increase to recover the former peak.

Some investors choose to avoid drawdowns of greater than 20% before cutting their losses and turning the position into cash instead.