What Is Drawdown?

A drawdown is a peak-to-trough decline during a specific period for an investment, trading account, or fund. It is usually quoted as the percentage between the peak and the subsequent trough. If a trading account has $10,000 in it, and the funds drop to$9,000 before moving back above $10,000, then the trading account witnessed a 10% drawdown.

Drawdowns are important for measuring the historical risk of different investments, comparing fund performance, or monitoring personal trading performance.

Formula and Calculation

The drawdown is typically calculated as follows:

$$\text{Drawdown} = \frac{\text{Trough Value} - \text{Peak Value}}{\text{Peak Value}} \times 100\%$$

Or more simply:

$$\text{Drawdown \%} = \frac{\text{Current Value} - \text{Peak Value}}{\text{Peak Value}} \times 100\%$$

Where:

• $\text{Peak Value}$ = The highest point before the decline
• $\text{Trough Value}$ = The lowest point during the decline
• $\text{Current Value}$ = The current portfolio value

Maximum Drawdown (MDD)

Maximum drawdown (MDD) is the maximum observed loss from a peak to a trough of a portfolio, before a new peak is attained. Maximum drawdown is an indicator of downside risk over a specified time period.

Maximum Drawdown Formula

$$\text{MDD} = \frac{\text{Trough Value} - \text{Peak Value}}{\text{Peak Value}} \times 100\%$$

The maximum drawdown considers only the largest drawdown, regardless of how long it took for the investment to recover. Because it measures only the largest drawdown, MDD does not indicate how long it took an investor to recover from the loss, or if the investment even recovered at all.

What Drawdown Can Tell You

Drawdowns help determine an investment's financial risk. Both the Calmar ratio and the Sterling ratio use this metric to compare a security's possible reward to its risk.

Key Insights from Drawdown Analysis

1. Risk Assessment: Larger drawdowns indicate higher volatility and risk.

2. Recovery Time: How long does it take to recover from drawdowns? This is crucial for understanding the investment's resilience.

3. Frequency: How often do significant drawdowns occur? Frequent drawdowns may indicate an unstable investment strategy.

4. Psychological Impact: Large drawdowns can be emotionally challenging and may lead to poor investment decisions.

Types of Drawdowns

Absolute Drawdown

The difference between the initial deposit and the lowest point below the initial deposit. For example, if you start with $10,000 and the account drops to$8,000, the absolute drawdown is $2,000 or 20%.

Maximum Drawdown

The largest peak-to-trough decline in the investment's history. This is the most commonly referenced drawdown metric.

Relative Drawdown

The maximum drawdown expressed as a percentage of the maximum equity value rather than the initial investment.

Drawdown Duration

Drawdown duration refers to the time period between a peak and return to the peak. This metric is important because:

• Recovery Period: It shows how long an investor must wait to recoup losses.
• Opportunity Cost: During drawdown, capital is tied up recovering rather than generating returns.
• Strategy Viability: Excessively long drawdown durations may indicate a flawed strategy.

Drawdown in Trading Strategies

For algorithmic trading and systematic strategies, drawdown metrics are crucial:

Acceptable Drawdown Levels

Risk Management Rules

Many professional traders follow the rule of limiting maximum drawdown to 20-25% before re-evaluating a strategy. Some funds have hard stops at specific drawdown levels.

Example

Consider a portfolio with the following value progression:

In this example:

• The maximum drawdown was 20% (from $110,000 to$88,000)
• The drawdown duration was 5 months (Month 2 to Month 7)

FAQs

What is a good maximum drawdown?

A "good" maximum drawdown depends on the investment strategy and risk tolerance. Generally, for balanced portfolios, a maximum drawdown under 20% is considered acceptable. For more conservative strategies, under 10% may be expected.

How do you recover from a drawdown?

To recover from a drawdown of X%, you need a gain of X/(1-X) × 100%. For example:

• 10% drawdown requires 11.1% gain to recover
• 20% drawdown requires 25% gain to recover
• 50% drawdown requires 100% gain to recover

Is maximum drawdown the same as volatility?

No. Volatility measures the dispersion of returns over time (both up and down), while maximum drawdown specifically measures the largest peak-to-trough decline. A strategy can have low volatility but still experience significant drawdowns.

The Bottom Line

Drawdown is a critical risk metric that every investor should understand. It provides insight into the potential downside risk of an investment and helps set realistic expectations. When evaluating investments or trading strategies, consider not just the returns but also the drawdowns required to achieve those returns.