Maximum drawdown (MDD) is one of the most important risk metrics in trading and investing. It measures the largest peak-to-trough decline in your account value before reaching a new high. Understanding drawdown is essential for evaluating strategies, managing risk, and setting realistic expectations.
What is Maximum Drawdown?
Maximum drawdown represents the worst-case scenario you have experienced (or would experience) during a specific period. It shows the largest percentage drop from any peak to the subsequent trough.
Maximum Drawdown Formula:
MDD = (Peak Value - Trough Value) / Peak Value x 100%
Example Calculation
Imagine your account follows this path:
- Starting balance: $50,000
- Grows to: $65,000 (new peak)
- Drops to: $52,000 (trough)
- Recovers to: $70,000 (new peak)
- Drops to: $58,000 (current)
Drawdown from first peak: ($65,000 - $52,000) / $65,000 = 20%
Drawdown from second peak: ($70,000 - $58,000) / $70,000 = 17%
Maximum Drawdown: 20% (the largest of all drawdowns)
Why Maximum Drawdown Matters
Real Risk Measurement
Average returns can be misleading. Two strategies might both average 15% annually, but one might have a 10% maximum drawdown while the other has a 50% maximum drawdown. The first is clearly preferable for most traders.
Recovery Time and Effort
Drawdowns require disproportionate gains to recover:
| Drawdown | Recovery Needed | Difficulty |
|---|---|---|
| 10% | 11% | Manageable |
| 20% | 25% | Challenging |
| 30% | 43% | Difficult |
| 50% | 100% | Very Difficult |
| 75% | 300% | Nearly Impossible |
Psychological Impact
Large drawdowns are emotionally devastating. A 40% drawdown might cause you to abandon a perfectly good strategy just before it recovers. Knowing your strategy's expected drawdown helps you stay the course.
Types of Drawdown Metrics
Absolute Drawdown
The difference between initial capital and the lowest point. If you start with $50,000 and it drops to $45,000 before ever going higher, your absolute drawdown is $5,000 or 10%.
Maximum Drawdown
The largest peak-to-trough decline, regardless of starting capital. This is the most commonly used metric.
Average Drawdown
The mean of all drawdown periods. Useful for understanding typical risk, not just worst case.
Drawdown Duration
How long it takes to recover from a drawdown and reach new highs. Some drawdowns are brief and sharp; others are prolonged and grinding.
What is a Good Maximum Drawdown?
This depends on your trading style and time horizon:
- Conservative investors: Target less than 10% MDD
- Moderate traders: Accept 15-25% MDD
- Aggressive traders: May tolerate 25-40% MDD
- High-risk strategies: Sometimes exceed 50% MDD
General Rule: Your maximum drawdown should not exceed the point where you would emotionally break and abandon your strategy. Be honest with yourself about your tolerance.
The MAR Ratio: Risk-Adjusted Returns
The MAR ratio (named after Managed Account Reports) compares returns to maximum drawdown:
MAR Ratio = Annual Return / Maximum Drawdown
Examples:
- 20% return with 10% MDD = MAR of 2.0 (excellent)
- 20% return with 20% MDD = MAR of 1.0 (good)
- 20% return with 40% MDD = MAR of 0.5 (poor)
A MAR ratio above 1.0 is generally considered acceptable. Above 2.0 is excellent.
Reducing Maximum Drawdown
1. Strict Position Sizing
Risk 1-2% per trade maximum. This ensures no single trade causes catastrophic damage.
2. Diversification
Spread capital across uncorrelated assets, strategies, or timeframes. When one position loses, others may offset.
3. Stop Losses
Always use stop losses to limit individual trade losses. No hoping or praying for recovery.
4. Reduce Size in Drawdowns
When experiencing a drawdown, reduce position sizes. This slows the bleeding and protects remaining capital.
5. Maximum Portfolio Risk Limits
Cap total portfolio risk at 6-10% at any time. If you reach that limit, stop adding positions.
Monitor Your Drawdown in Real-Time
Pro Trader Dashboard tracks your drawdown automatically, showing peak values, current drawdown, and recovery progress.
Historical Drawdowns for Context
Understanding market history helps set expectations:
- S&P 500 (2008-2009): 57% drawdown
- NASDAQ (2000-2002): 78% drawdown
- S&P 500 (2020): 34% drawdown (recovered quickly)
- Average bear market: 30-40% drawdown
Even buy-and-hold investors experience significant drawdowns. Active traders should expect similar or larger depending on their leverage and strategy.
Drawdown and Psychology
Know Your Limit Before It Happens
Decide in advance what drawdown level would cause you to stop trading. Document this in your trading plan. When emotions are running high is not the time to make this decision.
Use Drawdown Rules
Many traders implement automatic rules:
- At 10% drawdown: Reduce position size by 50%
- At 15% drawdown: Stop trading, review strategy
- At 20% drawdown: Paper trade only until confidence returns
Separate Analysis from Emotion
A 20% drawdown might be perfectly normal for your strategy. Check historical performance before panicking. If it is within expected parameters, stay the course.
Summary
Maximum drawdown measures the largest decline from any peak to subsequent trough. It is arguably more important than total return for assessing a strategy's viability. Large drawdowns require disproportionately large gains to recover and can cause psychological damage that leads to poor decisions. Use position sizing, diversification, and stop losses to control drawdown. Track your drawdown continuously and have predefined rules for when to reduce risk. Remember: survival comes first, profits come second.
Learn more: the 1% rule and portfolio risk assessment.