Key Highlights

The maximum drawdown (MDD) is a trading metric that helps track the most significant percentage decline in the value of a trade over a certain period. In a nutshell:

• MDD measures the highest decline in an investment’s value as given by the difference between the value of the highest peak before a decline and that of the decline.
• By establishing the difference between the highest peak and lowest trough values, the maximum drawdown helps indicate the volatility of the investment’s value in the past.
• Traders can use this value to predict how prices will move in the future, helping a trader prevent losses.
• Apart from associated risk, MDD can also act as an indicator for market performance.

Max Drawdown

Traders traditionally judge investment performance based on the returns received. But as many seasoned investors will tell you, returns don’t always tell you the whole story. This is because you can have two investment portfolios landing at the same place despite taking two very different paths. 

On one hand, you’ll have a path that feels manageable, while the other one feels unbearable. The difference that exists between these two paths is what traders call a drawdown, and the maximum drawdown is the method used by prop firms to measure it. 

The maximum drawdown is a measure of the worst decline experienced by a portfolio before it has begun its recovery journey, and is a reflection of not only the financial loss incurred, but also the emotional pressure experienced. 

Understanding how the maximum drawdown works can help you as a trader to choose a trading strategy that will ensure you don’t deviate from it. Read on to learn more about how to calculate the maximum drawdown!

What Is Max Drawdown In Trading?

The maximum drawdown (MDD) is a trading metric that helps track the most significant percentage decline in the value of a trade over a certain period. Theoretically, this drawdown assists in identifying the peak and trough value of an investment or portfolio, i.e., the volatility risk.

In my years in the trading space, I have come to note that mutual funds and hedge funds keep track of the MDD of their portfolio as a means to quantify their downside risk and to provide them with a historical precedent for future reference. 

From a backward-looking perspective, I believe that the question that the maximum drawdown seeks to answer is one: ‘What is the total decline (percentage-wise) in the value of a certain investment from its highest attained value to now?’

Looking at the historical drawdown experienced up to this point, a trader should be able to alter their investment plan to lower the downside risk potential of their investment moving forward.

But as I have come to see, the maximum drawdown of the investment that’s presently being analyzed is often more meaningful to portfolios that have long performance data. 

The reason for this is that such a portfolio will likely have undergone a full economic cycle, which will have captured a bull (profit-making) run and bear (recession) run. 

How to Calculate Max Drawdown

Three points are considered when calculating the MDD: the peak, trough, and the recovery that follows. Here are the steps:

1. Establish the portfolio’s peak value
2. Identify the trough value
3. Take the trough value and subtract it from the peak value
4. Divide the resulting difference by the peak value
5. Take this result and multiply it by 100 to convert it into a percentage

And this is where:

Peak Value = Highest (top) value of a portfolio

Trough Value = Lowest (bottom) value of the investment

The Max Drawdown formula is:

Maximum Drawdown = (Peak Value - Trough Value) ÷ Peak Value

Let’s look at an example to get a sense of how this formula truly works.

Your portfolio grows from $10,000 to a new high of $15,000, before going on a bear run that sees it closing at $11,000. The bear run is then followed by a bull run. 

For us to calculate the maximum drawdown here, we will use the max drawdown formula provided earlier, and this is how the calculation will be:

(15,000 − 11,000) ÷ 15,000 = 26.7%

Please note that while the portfolio appears stable, the drawdown experienced in our above example is quite significant. And this gap that sits between the long-term returns and the pain experienced in the short term is what makes drawdowns, and maximum drawdown in particular, psychologically challenging. 

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What Is A Trailing Max Drawdown?

A trailing maximum drawdown refers to a dynamic risk management tool that prop trading firms use to set the maximum permitted decline from your funded account’s peak value. The drawdown locks or trails new profit ticks and will continue to tighten as the account scales. While this can help reduce risk, it does make it easier to breach the drawdown limit if you fail to secure your profits. 

Key Rules and Characteristics

• Dynamic Limit: This limit, unlike the static drawdown {Link up to Static Drawdown}, trails upwards alongside the trading account’s peak balance.
• Breach Failure: Hitting the maximum drawdown limit will lead to the automatic closure of all your open positions and subsequent termination of the funded account.
• Lock in Point: In most cases, once the account has hit a predefined profit target, the trailing drawdown will immediately cease moving, providing you with additional flexibility. 
• Never Decreases: If the funded account balance dips after attaining a new high, the trailing max drawdown will remain at this level, instead of moving down with the losses incurred. 

Why Maximum Drawdown Is More Important than Volatility 

Volatility is a measure of how much prices on the open positions fluctuate. Maximum drawdown, on the other hand, looks at how much damage these fluctuations are likely to cause to your investment portfolio. And here are the reasons why drawdown matters more:

• It reflects a lived experience: Traders rarely feel the impact of standard deviations. For them, what matters are the losses incurred from peak positions.
• Drawdown makes it harder to recover as it increases. For example, if you have a 10% drawdown on your account, you’ll need at least 11% to fully recover. This asymmetry is why traders feel the need to control drawdowns, as opposed to going after bigger returns. 
• Similar returns in two different portfolios, but different pain for the traders involved: Two different investment strategies may both provide a 15% annual return. And while one may experience a 12% drawdown, the other portfolio will likely suffer a 45% drawdown. Looking at these two results, many investors will abandon the second portfolio long before its results have materialized. 

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Common Causes of Large Drawdowns and Why Traders Track Maximum Drawdown

Most severe drawdowns experienced by traders aren’t a result of one bad trade. They come about due to repeated exposure to unmanaged risk. Typical causes of large drawdowns include:

• Emotional rule-breaking (revenge trading) during losses
• Oversized position sizing
• Sudden market changes
• Highly correlated trades

Maximum drawdown is considered an important risk metric in drawdown trading. The following are the top reasons why traders track maximum drawdowns:

• To test psychological tolerance
• To understand worst-case scenarios
• To compare strategies beyond headline recoveries
• To realistically size their positions 

As a trader, you must always be aware of the fact that a strategy can be profitable on paper, but impractical and loss-making when the drawdowns exceed comfort levels. 

Conclusion

MDD measures the deepest loss that your strategy or portfolio experiences before it kickstarts its recovery. Traders use it to establish the real cost attached to a trading risk, both emotional and financial. By understanding what a maximum drawdown is and how to calculate it, you’re better placed to choose a strategy that aligns with your risk tolerance. If you want to learn how to manage risk and monitor drawdowns, check out the tools and resources provided by Audacity Capital - a premier prop trading firm. 

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