The maximum reduction in value from the peak value for an investment or fund that has occurred over a period of time.
What Is Drawdown?
The term “drawdown” is usually used when referring to the maximum reduction in value from the peak value for an investment or fund that has occurred over a period of time. For example, over a period of three years, how much could an investment fall from its highest value? This maximum drop in value over the period is known as drawdown.
Calculating drawdown can indicate how risky an investment or fund is and help you make an informed decision as to whether it is right for you. The greater the potential of decrease in value, the riskier the fund. If you are concerned about volatility and want a smoother investment ride, you can opt for a fund with lower drawdowns.
Drawdown is a measure of an account’s peak-to-valley decline during a specific recorded period of time. Drawdown represents the difference between the balance and equity at any given point in time, usually used in trading.
It can be used to test how robust a trading strategy or model is over that period, or as an estimate of how much equity capital would have been required to avoid drawdowns below certain thresholds.
Drawdown is calculated with the following formula:
MDD = (Trough Value — Peak Value) / Peak Value
How to Calculate Drawdown?
The first step in calculating drawdown is finding the largest peak in your equity curve. This will be the point of reference when calculating MDD.
Once you know where the highest peak in your equity curve is, you must find the lowest point. The difference between these two values divided by the highest point will give you your MDD.
For example, if account equity reaches $10,000 after a trade entry and then falls to $9,500 before rising again to $10,500 later on, we’ve had one drawdown of $500 or 5%. A lower MDD means less risk and that’s why it’s considered important by many traders.
While an investment’s rate of return is important, it doesn’t provide the full picture when considering how risky it is. An investment may have a high rate of return, but if its value falls significantly before rising again, investors would experience greater volatility and be more likely to sell at a loss. The drawdown provides investors with additional information to understand how much money they could lose on a particular investment.
Max drawdown is used primarily to assess risk in a portfolio of securities. A higher MDD indicates greater risk, while a lower MDD indicates lower risk. For example, if an investment fund has an average return of 10% but its maximum drawdown is -20%, it means that while the average annual return was good, there were times during which investors could have lost 20% on their investment – had they bought at the top and sold at the bottom.
The maximum drawdown can be calculated by either comparing daily trading prices or monthly account balances. The first method is more useful for traders, who want to know their maximum loss on daily basis, and the second method serves better for investors who are more interested in longer-term returns.