Every trader experiences losing streaks. The question is not whether you will have drawdowns, but how severe they will be and whether you can survive them. Maximum Drawdown (MDD) measures the worst peak-to-trough decline in your trading account and is arguably the most important risk metric you should track.
What is Maximum Drawdown?
Maximum Drawdown measures the largest percentage drop from a peak to a subsequent trough before a new peak is established. It shows you the worst loss you experienced during a specific period, even if your account eventually recovered.
The simple version: Maximum Drawdown answers the question: "What was the worst losing streak I had?" It measures how far your account fell from its highest point before recovering. It is the most painful part of your equity curve.
Why Maximum Drawdown Matters
MDD is critical for several reasons:
1. Survival Threshold
A 50% drawdown requires a 100% gain just to break even. A 75% drawdown requires a 300% gain. The math of recovery works against you as drawdowns get larger.
The Math of Recovery
- 10% drawdown requires 11.1% gain to recover
- 20% drawdown requires 25% gain to recover
- 30% drawdown requires 42.9% gain to recover
- 50% drawdown requires 100% gain to recover
- 75% drawdown requires 300% gain to recover
- 90% drawdown requires 900% gain to recover
2. Psychological Impact
Large drawdowns test your emotional discipline. Many traders abandon good strategies during drawdowns, locking in losses that might have recovered. Knowing your typical MDD helps you mentally prepare for inevitable rough patches.
3. Position Sizing
Your acceptable maximum drawdown determines how much capital you should risk per trade. If you cannot tolerate more than a 20% drawdown, you need to size positions accordingly.
How to Calculate Maximum Drawdown
The calculation tracks the running peak and measures declines from that peak:
Calculation Steps
- Track your account value over time
- At each point, note the highest value reached so far (the peak)
- Calculate the current decline from that peak: (Peak - Current) / Peak
- The Maximum Drawdown is the largest of these decline values
Example Calculation
Account values: $10,000 - $12,000 - $11,000 - $9,500 - $10,500 - $13,000
| Value | Peak | Drawdown |
|---|---|---|
| $10,000 | $10,000 | 0% |
| $12,000 | $12,000 | 0% |
| $11,000 | $12,000 | 8.3% |
| $9,500 | $12,000 | 20.8% |
| $10,500 | $12,000 | 12.5% |
| $13,000 | $13,000 | 0% |
Maximum Drawdown = 20.8%
What is a Good Maximum Drawdown?
Acceptable MDD varies by trading style and risk tolerance:
- Conservative (less than 10%): Typical for income-focused strategies, options selling, or risk-averse investors.
- Moderate (10-20%): Common for diversified portfolios and swing trading strategies.
- Aggressive (20-30%): Acceptable for growth-oriented strategies and experienced traders.
- High Risk (30-50%): Typical for concentrated positions, leveraged strategies, or early-stage trading accounts.
- Extreme (above 50%): Generally considered too risky for most traders. Recovery becomes extremely difficult.
Related Drawdown Metrics
Besides Maximum Drawdown, several related metrics provide additional insight:
Average Drawdown
The average of all drawdowns during a period. A strategy with a 20% MDD but 5% average drawdown is generally preferable to one with a 20% MDD and 15% average drawdown.
Drawdown Duration
How long it takes to recover from a drawdown. A 15% drawdown that recovers in two weeks is less painful than one that takes six months to recover.
Calmar Ratio
Annual return divided by Maximum Drawdown. This metric helps you understand return per unit of maximum risk. A Calmar Ratio above 1.0 means your annual return exceeds your worst drawdown.
Calmar Ratio Example
Annual return: 25%
Maximum Drawdown: 15%
Calmar Ratio = 25% / 15% = 1.67
This indicates strong performance, with returns significantly exceeding the worst drawdown.
Strategies to Reduce Maximum Drawdown
Controlling drawdowns is essential for long-term trading success:
1. Position Sizing
The most effective way to control drawdowns is through proper position sizing. Risking 1-2% per trade mathematically limits how much you can lose during a losing streak.
2. Stop Losses
Consistent use of stop losses prevents any single trade from causing excessive damage to your account.
3. Diversification
Trading multiple uncorrelated strategies or assets reduces the impact when one strategy struggles. Learn more about correlation in trading.
4. Drawdown Rules
Implement rules that reduce position size or pause trading during drawdowns. For example, cut position size in half after a 10% drawdown.
5. Volatility Targeting
Reduce position sizes when market volatility increases. This helps maintain consistent risk exposure across different market conditions.
Pro tip: Whatever Maximum Drawdown you experience in backtesting, expect it to be larger in live trading. Markets do things they have never done before, and live trading adds psychological pressures that do not exist in backtests.
Using MDD for Strategy Evaluation
When evaluating trading strategies, consider MDD alongside returns:
Strategy Comparison
| Strategy | Return | Max DD | Calmar |
|---|---|---|---|
| A | 40% | 35% | 1.14 |
| B | 25% | 12% | 2.08 |
| C | 18% | 8% | 2.25 |
Strategy A has the highest return but the worst risk-adjusted performance. Strategy C, despite the lowest return, has the best Calmar Ratio. You could potentially leverage Strategy C to match Strategy A's returns while maintaining better risk control.
Historical Maximum Drawdowns
Understanding historical drawdowns provides context:
- S&P 500 (2007-2009): 56.8% drawdown during the financial crisis
- S&P 500 (2020): 33.9% drawdown during COVID crash
- NASDAQ (2000-2002): 78% drawdown during dot-com bust
- Bitcoin (2017-2018): 84% drawdown
Even buy-and-hold investors experience severe drawdowns. Active traders should expect similar or larger drawdowns unless they actively manage risk.
Psychological Preparation
Knowing your strategy's expected MDD helps you prepare psychologically:
- Expect drawdowns: They are a normal part of trading, not a sign of failure.
- Size for survival: Only trade with money you can afford to see decline by your expected MDD.
- Trust your process: If you have tested your strategy, stick with it through drawdowns.
- Review, do not panic: Use drawdowns as learning opportunities, not reasons to abandon your approach.
Track Your Drawdowns Automatically
Pro Trader Dashboard calculates your Maximum Drawdown, average drawdown, and recovery time automatically. See exactly how your account has performed through its ups and downs.
Summary
Maximum Drawdown is the most important risk metric for traders because it directly measures your worst-case scenario. Understanding and controlling your MDD helps ensure you survive long enough to profit from your trading edge.
Combine MDD analysis with other risk metrics like the Sharpe Ratio, Sortino Ratio, and Value at Risk for a complete picture of your trading risk profile.