One of the key steps to becoming an evolved investor with eToro is definitely identifying the risks of each investment, and one of the key elements to determine the risk of the investor’s trading strategy is the Drawdown.
65% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.
(Would you like to find out more about how eToro works? Read our guide on how eToro works from the beginning)
Risk and Reward
In the investment world, if you want to gain you have to risk something.
The yield is always linked to the risk. Usually, the greater the risk and the greater the possibility of return. But sometimes it’s not so, and paradoxically you can risk a lot to have very low yields.
So the first goal of an investor, be it a social trader or other nature, it must be precisely to identify, understand the risk and then try to limit it as much as possible.
That’s why we at InvestinGoal, before speaking of returns, first thing we always talk about risks and the identification of possible dangers. It’s not a lack of optimism, and we also know that commercially it may not be the best approach, but when it comes to investing capitals there’s no possible excuse, because the first main goal to be sponsored is without any doubt the preservation of capital.
In other words, your first priority should be to identify the extent of the risk to which you are subjecting your account.
First protect, and then earn.
Obviously, when you will know how to identify and manage the risk of your portfolio, the next step will be to find the investment (the traders) who, with the same risk, will give you the highest returns.
The risk of a people-based-portfolio is related to the operational style of the individual investors you will decide to replicate and their total composition in your portfolio.
The risk associated with an individual investor depends on:
- his capacity to trade;
- the strategy he uses;
- the tools he uses;
- their volatility.
One of the fundamental elements to understand the riskiness of the investment strategy used by the trader is precisely the calculation of drawdown.
Drawdown is the intensity of the reduction in value of a capital sum, in percentage or absolute terms, and may be referred to a single order or to the entire strategy.
One of the first things we do when we get in touch with a Social Trading company is indeed to verify if it shows this data correctly, or otherwise, to understand in detail how it is expressed and why.
If you want more information about DrawDown you can find them in the Equity line and DrawDown lesson.
The Drawdown figure of eToro
At eToro you can find the drawdown figures in the Statistics section of the profile of a trader or Popular Investor.
Studying the Drawdown is crucial to:
- understand the fluctuations to which your capital can be subjected with that particular strategy;
- understand how the trader acted in the loss phases, i.e. in times of higher risk.
As I mentioned, within the profile, stats section, there’s the module dedicated to the risk, where we find precisely the Drawdown data.
The data provided by eToro are related to Max DrawDown, namely the maximum losses, and are:
Daily: maximum negative swing of the account during a day;
Weekly: maximum negative swing of the account during a week;
Yearly: maximum negative swing of the account during a year.
How eToro calculates the Max Drawdown
EToro, as opposed to other Social Trading companies (see the ZuluTrade Drawdown), provides the conventionally recognized result of Max Drawdown.
It’s not something obvious, as other companies provide a Max DrawDown value calculated differently from what is reported in the classic manuals of financial mathematics.
EToro makes a daily calculation of profits/losses through the new formula that replaces the old modified Dietz (see the previous lesson to find out the calculation). The new formula uses as data the assets at the end and start of the day (which in eToro corresponds to the value Account Balance, plus or minus the equivalent of open positions in the market in Net Profit), while ensuring that this value is distorted by any deposits or withdrawals.
Although the formula used to calculate the DrawDown is correct, the fact that the calculation is applied not to the entire Trader’s history but rather only to time portions (worst day, week or year) gives Max DrawDown results potentially erroneous, and therefore makes the Drawdown value shown by eToro of little use.
It is certainly useful to see different time horizons. Observing this value to one day, one week and one year, makes you realize the possible fluctuations in the account for different time frames.
But the problem remains that these values are not accompanied by a calculation on the entire operating history of the trader, which would give you the correct maximum DrawDown figure, which is in fact the most important value for determining the operational risk of an investor.
Despite the clear improvement of eToro in data sharing, this is still a legacy of the old style, where oversimplification was at the expense of effectiveness and usefulness.
Being an investment of money, it would be far preferable to have access to all the data available.
Also, what you can notice is the absence of the most important figure, the overall Max DrawDown, which is the maximum negative event ever occurred since the beginning of operations of the trader up to the moment of your analysis.
The maximum depth of analysis therefore is still with the last year (Yearly figure).
One year history is certainly significant, but if the investor has an operating history of five years, it becomes an unrepresentative figure.
For example, it might be that an event that really put under stress the operational strategy of the investor occurred three years ago. If the max DrawDown would have had an overall depth, you’d be able to detect it, but with the current depth of analysis provided by eToro, this is not possible.
How to proceed
Thanks to a new feature of the eToro platform we can partially improve this situation.
EToro has recently introduced a new Charts section you can easily access from any trader profile.
In this section you can find an equity line showing the evolution of the trader’s balance. The actual amount of the trader’s balance is not shown (for privacy reasons), but the equity line is built on a hypothetical starting balance of $ 10,000.
For our purpose, though, is totally fine.
You can view the graph up to a depth of two years. This means that, manually, we can see and calculate the Max Drawdown of the last two years.
As said before, the trader could also have a much longer history, even up to 5 years, so in that case you won’t be able to tell if that Max DD you’re finding on this chart is really the greatest.
But if the trader’s history is less or equal to 2 years, you can be sure you have found the true total Max Drawdown.
Let’s see how.
Click on the button to enlarge the chart. This way you can access the Period options and choose “Last two years”.
Then click on the button to activate the cursor to visualize the values of the point on which you position.
At that point you have to visually find what you think to be the largest drawdown, the deepest.
With the cursor position on two points, and then write down the values of these two points:
- first on the highest point reached before the start of the drawdown
- then on the lowest achieved by the same Drawdown
Now, with the two values in hand, to understand how much the Drawdown percentage is, you can use a percentages calculator (there are many on the internet), or you can also do it on your own.
First thing, do a subtraction and find the DD in absolute terms, i.e.:
Point 1 – Point 2 = Absolute DD value
Then, simply divide these result for the value of the point 1, therefore:
(Absolute DD Value) / Point 1 = Max DD percentage
To make an example with the image data:
123.672 $ – 94.143 $ = 29.529 $
29.529 $ / 123.672 $ = 0,238 (x100)
= 24 % Max DD percentage
As you can see from the first image of the lesson, eToro, for Noa Trijbox, shows an annual drawdown of 16.93%.
What we have found manually with this method, instead, shows a 24%.
You can understand by yourself the importance of working in this way in order to achieve the most truthful data possible.