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Drawdown and Max Drawdown

Imagine a roller coaster ride through the unpredictable landscape of financial markets, where prices rise and fall. Just as a roller coaster has its thrilling drops, the world of trading has its own heart-pounding moments known as 'drawdowns’! Keep scrolling to find out what exactly drawdowns are and discover the effective strategies to minimize them!

What Is a Drawdown?

Generally, a drawdown refers to the value drawn from a trading account, an investment, or a portfolio during a specific period. In other words, it calculates the most significant drop in the value of an investment, trading account, etc., from its peak to its trough during a given time period before a new peak is reached.

Drawdowns are frequently used to measure the risk and potential loss of an investment, as well as to track the trader's performance.

In trading, traders and investors commonly analyze several types of drawdowns to understand the performance and the risk of their trading strategies. Keep reading to learn about different types of drawdowns!


What Is the Equity Drawdown?

Equity drawdown, the most commonly used type, describes the difference between the equity’s maximum level reached(Peak) and the equity’s minimum level reached (trough) during a specific period of time.

When calculating equity drawdown, we must consider the portfolio's total value, including the initial investment and any additional profits or losses during a specific period. In other words, equity drawdown refers to the decline in the overall value of a trading portfolio from its peak value to its lowest point before a new peak is reached.


Equity Drawdown = Maximum value of equity – Minimum value of equity

Let’s say you opened two positions in the EUR/USD currency pair with an initial account value of $20,000. During the first hour of your trade, your account’s equity starts rising and reaches $23,000, and following the next hours, your account’s value drops to $15,000.

As a result, the equity drawdown during this period is calculated by subtracting the equity’s peak from its trough. Equity Drawdown = $15,000 - $23,000 = - $8,000


What Is the Relative Drawdown?

Relative drawdown describes the equity drawdown ratio to the equity's peak value in a percentage. Relative drawdown is an important indicator since it provides traders with insights into the risks associated with their trading strategy.

A high relative drawdown percentage indicates that the strategy has suffered significant losses, possibly becoming unsustainable in the long-term prospects. A low relative drawdown percentage, on the other hand, demonstrates the strategy's ability to mitigate losses even during periods of market volatility.

Traders should strive to maintain a low relative drawdown percentage since doing so reduces the risk of losing a significant amount of their trading account.


Relative Drawdown(%) = (Equity Drawdown($) / Peak Equity($)) * 100

Regarding the above example, the relative drawdown is calculated as follows. Relative Drawdown = (-$8,000 / $23,000) * 100 = -34.78%

What Is the Maximum Drawdown (MDD)?

A maximum drawdown (MDD) refers to the most significant decline in the trader’s account or an investment fund from a peak to a trough before a new peak is reached. It is critical to understand that this metric only estimates the amount of the highest loss without taking into account the frequency of such severe losses.

Professional traders tend to have a lower maximum drawdown, as it indicates that their trading account is associated with slight losses, meaning that they have managed their risks effectively. The greatest drawdown would be 0 in the unlikely event that their trading account never lost money.

In contrast, the most severe possible maximum drawdown would be -100%, indicating a full loss of the trading account’s value.


Maximum Drawdown = Max[(( Trough Value - Peak Value ) / Peak Value) * 100]

Turning back to our first example, envisage that the value of your portfolio fluctuates due to market movements as follows throughout the entire trading period.
  • Initial value = $20,000
  • After one year = $26,000
  • After two years = $24,500
  • After three years = $16,000
  • After four years (final year) = $23,500

In the case of the above example, the most significant drop regards the decline from $26,000 to $16,000. Hence, the maximum drawdown is calculated as follows.

Peak Value = $26,000

Trough Value = $16,000

Maximum Drawdown = (( $16,000 - $26,000 ) / $26,000) * 100 = -38.46%


What Does Maximum Drawdown Describe?

A maximum drawdown defines the largest downside risk associated with an investment or trading strategy. It clearly measures the worst performance that could have been realized during a trade or investment.

Regarding the above example, a -38.46% drawdown represents that during an entire trading period, the value of your trading account has dropped by -38.46% from its highest recorded value before recovering.


What Is the Absolute Drawdown?

When applied to a trading account, absolute drawdown refers to the exact money difference between the initial account balance and the lowest point the account achieves during a certain trading period. Absolute drawdown, as opposed to relative drawdown, which is stated as a percentage of the initial balance or equity, gives a clear numerical indication of the actual money amount lost throughout the trading period.

When it comes to professional trading, understanding absolute drawdown is critical since it provides traders with a solid understanding of the actual financial losses sustained in their trading endeavors. Absolute drawdown offers an essential insight beyond percentage data for traders who emphasize understanding the actual monetary effect of losses.

Suppose a trader begins with an initial trading account balance of $10,000. Over the course of several months, they execute several trades, and the account balance reaches a low point of $8,000. In this scenario, the absolute drawdown would be calculated as follows.


Absolute Drawdown = Initial Balance - Lowest Account Balance

Absolute Drawdown = $10,000 - $8,000 = $2,000 Therefore, the absolute drawdown would be $2,000. This indicates that the trader's account balance experienced a $2,000 decline from its highest point to the lowest point during the trading period. This amount gives the trader a direct understanding of the financial impact of their trading decisions and strategies.

Distinguishing Drawdown and Loss in Financial Markets

It's important to distinguish that the idea of drawdown and the financial market’s losses are two separate topics. To better grasp, assume that Sarah begins trading and makes a series of trades over a month with an initial deposit of $10,000.

After a series of trades, the value of Sara’s portfolio fluctuated; at one point, her portfolio's value dropped to $8,000. However, after three weeks, her portfolio recovered and peaked at $10,500, and finally, a week later, Sara closed her positions, bringing her trading account’s value to $9,500. During this time, her account experienced both drawdowns and losses.

This $2,500 decrease in portfolio value from its peak value of $10,500 is considered a drawdown, highlighting how much her portfolio has temporarily lost in value during a particular period. However, a loss refers to a negative return on that particular trade, and in this case, Sarah’s portfolio has incurred a loss of $500 during the same period.


What Causes Drawdowns and How to Avoid Them?

Drawdowns are an integral part of an investment or trading due to the inherent uncertainty in financial markets. They can be caused by various factors, including market conditions, trading strategies, external events, lack of diversification, overtrading, lack of experience, etc.

Risk management techniques, such as position sizing, leverage management, risk reward ratio, backtesting, education, etc., play a crucial role in order to dwindle our risks and avoid significant losses. Are you curious about effective risk management strategies?

No need to worry anymore! Feel free to explore here to diminish the possibility of losses and enhance the overall success of your trading!


The Bottom Line

Overall, understanding the concept of drawdown is essential in evaluating the performance and risk of trading strategies. Although drawdowns are an inescapable reality in the world of trading, several risk management techniques are acting as armor against excessive drawdowns and colossal losses. At ITB, we are entirely devoted to being by your side, offering deep expertise, and helping you confidently embark on your journey!
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Which of the following statements accurately describes the maximum drawdown (MDD) in trading and investing?

In the context of trading and investing, what is the primary purpose of calculating the relative drawdown?