Max Drawdown

Max drawdown is the largest peak to trough decline in a portfolio or strategy over a given period. It measures the worst cumulative loss an investor would have experienced before a new high was reached.

Calculation

Max drawdown is calculated from the equity curve by identifying the maximum decline from a local peak to the subsequent lowest point. The result is usually expressed as a percentage of the peak value. It is a path dependent metric that depends on the sequence of returns.

Why It Matters

Max drawdown captures tail risk that average volatility does not. It is widely used to compare strategies with similar returns but different downside profiles. Many risk policies set maximum drawdown limits to protect capital.

Practical Use

Traders use max drawdown in backtests, risk reports, and investor communications. It is often paired with recovery time, which measures how long it takes to regain the previous peak. In portfolio construction, drawdown limits can guide position sizing and leverage.

Limitations

Max drawdown is backward looking and does not predict future losses. It can be sensitive to the measurement period and to isolated shocks. Two strategies can share the same max drawdown while behaving very differently day to day.

Conclusion

Max drawdown is a critical risk metric for trading strategies. It provides a clear view of worst case historical loss and helps set realistic risk limits.