What Is Maximum Drawdown?
by Trader Rich
What is maximum drawdown? Why and how do I calculate it?
First, what is maximum drawdown? It is defined as the largest drop of a given asset within a certain time period.
Why calculate it? I've never made it a point to calculate maximum drawdown but I'm going to now. This is my attempt to start looking at more "advanced" money management concepts so I've decided to start with one of the easiest. The reason for calculating maximum drawdown is to measure the riskiness of your trading strategies. It will also give you an idea of how much money you could lose at some indeterminate point in time.
How do I calculate it? During the history of your trading strategy, I'm sure you'll be keeping track of your change in equity from one day to another, one week to another, one month to another, or whatever time period you choose. In the course of your trading, you will calculate drawdown which "represents the total percentage loss experienced by
a strategy before it starts winning again … and drives the
investment balance back up." (Source: http://www.confidentstrategies.com/maximum-drawdown.htm)
In this picture (Source: http://www.autumngold.com/Performance/DescriptionDD.htm), the drawdown is calculated with the following formula:
(Valley VAMI – Peak VAMI) / Peak VAMI
The Valley VAMI is the red arrow or approximately $1,100.
The Peak VAMI is the green arrow or approximately $1,425.
Therefore the drawdown is ($1100 – $1425)/$1425 or -22.8%.
Let's do 1 more example from the picture above. First let's find the Peak prior to the green arrow.
The Peak VAMI is approximately $1,250.
The Valley before the green arrow is at approximately $1,150.
Therefore the drawdown is ($1150-$1250)/$1250 or -8%.
So to find the maximum drawdown, select the drawdown that was greatest, in our example, -22.8%.
It’s not necessarily a maximum single period loss (although I suspect in the case of the competition thus far it is just a single period loss for most people), it’s the percentage difference between a peak in equity and a subsequent trough in equity. The trough can be anytime in the future, so 20 1% down days would be a bigger drawdown than one 5% down day.
It also doesn’t need to be consecutive losers, you can have a number of up days between your peak and trough.
Have a look at http://www.confidentstrategies.com/maximum-drawdown.htm for a diagram.
feel free to delete my last comment, your post is much clearer now
Thanks Milton… I appreciate your comments and it made me go out and understand maximum drawdown much clearer than before…
Hi,
I know this is an old post, but did you ever manage to complete the maximum drawdown calculator? I am a daily user of your position calculator, thanks for that, it is very useful.
Thanks, I was looking for this.