Smaller drawdowns
A drawdown is a peak-to-trough decline in an open investment’s value. For example, if a trade reached unrealized profits of $10,000 one day, and the next day fell to $6,000, that would indicate a $4,000 drawdown. While drawdowns do not necessarily dictate whether a trade will ultimately be a winner, managing drawdowns is important because it’s money that is at risk of being lost. In addition, a strategy’s maximum expected drawdown (based on historical modeling) will determine how much money a trader needs to allocate to that particular strategy. For example, if a strategy has a maximum drawdown of $5,000, we would need access to at least $5,000 to cover any potential losses. Because losses from a losing position are tempered by gains in a winning position, pairs trading generally involves smaller net drawdowns.