Calculating Maximum Drawdown and Its Impact on Your Capital Strategy

When risk comes up in traders’ conversations, most think of stop losses or position sizes right away, but there is another measure of risk that is undoubtedly overlooked, which is maximum drawdown. Maximum drawdown will tell you how much money you might lose in a single trade, but it will also tell you how far your account capital might go down during a losing streak.

Drawdown is not the sexiest thing to wrap your head around, but it is one of the most valuable means by which to prepare yourself for the actualities of trading. Boring as it may be, maximum drawdown is one of the worst outcomes you can imagine. Not being knowledgeable of maximum drawdown could lead to completely unrealistic expectations, poor trading strategies, and ultimately destructive account wiping positions.

What Is Maximum Drawdown?

In a general sense, maximum drawdown (MDD) is defined as the maximum drop in your account balance from a defined equity peak to a trough (low price point) before it climbs back to at least that peak. A maximum drawdown simply defines how much capital you have lost during the largest drawdown of your trading account.

As an example, if your account cap is $10,000, the account peaks, and then maybe you go through 5 losing trades. At that point in time your account may have gone down to $7,000, or down to $3,000 from its peak values.  In this case your MDD would be ($3,000) or maximum drawdown represents a maximum drawdown of 30% from your peak balance.

Why it Matters More than You Think!

In essence, drawdown is about more than numbers, it is about survival and psychology.  A huge maximum drawdown does more than just disadvantage your capital - it can ruin your confidence as a trader. Many traders ‘throw in the towel’ and quit after a massive drawdown. They may believe their account is shot, but in actuality, most cannot tolerate the emotional stress of having gone through a maximum drawdown.

Furthermore, the greater the drawdown you are subject to, the significantly more difficult it may be to take back a competitive return as you begin to start winning trades once again. In reality, if you were to lose 10% of your account capital, you would only need to gain around 11% to get back to last peak equity.Should you suffer a loss of 50%, you will need to have a 100% gain in your account to get back to where you started. 

Here is a simple chart to convey this point: 

It is for this reason controlling drawdown is essential to a long-term capital strategy. 

How To Calculate Maximum Drawdown

The formula for maximum drawdown would look something like this: 

MDD = (Peak Value - Trough Value) / Peak Value x 100

Using the previous example: 

Peak Value = $10,000

Trough Value = $7,000 

Calculation = (10,000 - 7,000) / 10,000 x 100 = 30%

There is no need to employ fancy statistics to derive value out of this. Simply tracking your account balance over an extended period--along with supplementary notes on the largest drops in your accounts balance--will yield insight into your historical drawdown. 

Drawdown and Your Trading Strategy

Maximum drawdown tells you much regarding the potential sustainability of your trading strategy/approach. If your strategy has a fairly consistent rate of large drawdown without losing profits, then you might not have a strategy capable of longer term growth.

The type of trading strategy that we want isn’t necessarily the one with highest possible profitability. Instead, it is the strategy with the lowest drawdown, yet generates profits. What good is a return of 200% overall if you must have a drawdown of 70% at some point during the time horizon? Most traders cannot mentally withstand, yet reach a 200% return, or any other gain, and do not have the capital to afford to so. 

The psychological factor of drawdown

Imagine the loss in your account being down 40%. 

Even when you have a logical assumption of the possibility of recovery, things are extremely stressful. Many traders abandon their strategy during these period, by switching strategies, loss chasing, or impulsively taking trades. These type of actions often lead to the different results that turn the temporary draw down or loss into a permanent one.  

When you have an idea of how to prepare for a draw down by having parameters around a draw down amount and mental preparation for in-process draw down period, it creates a great deal of ease and chance of success due to reduced fear driven decision making.

Controlling and Limiting Drawdowns

The great news is that you are not powerless attached to a draw down. There are several small deliberate maneuvers that can assist you to control a draw down:

Position Size: Do not risk too much on one trade. Keep it small- 1-2% at most on one trade. 

Diversification: Do not put all your eggs in one basket with one pair or set up. Spread out your risk. 

Using these principles, draw downs may still happen, but they can be smaller and more recoverable.

A real life example

Now let's say both traders grow their accounts to 20 thousand. 

Trader "A" is aggressive and risks 10% on a single trade while trader "B" is conservative and only risks 2%. Trader "A" sees his account drop to $10,000, his strategy resulted in a 50% draw down. He needed to recoup his capital from grieving a 100% double on the account he built. Trader "B" experiences the same losing streak but she only risks 2% on a single trade and sees the same account drop to 16 thousand, only a 20% draw-down. Recovery would happen when  either happens when only accomplishing a 25% return in the future and that is not unrealistic. 

Both traders' experienced losses, but the difference is only one of them can move on and recover as long as they kept having the trade set up to adjust to.

Final Thoughts

Maximum draw down is not the hottest topic in trading but it may just be the most important. It shows you how much pain your strategy can put you through for a maximum draw down potential awaits, and if your plan for your capital can handle it. 

When you think about your drawdown and plan around it, you really set yourself up to give yourself a better chance to continue to operate in the long term financially and to some level emotionally. 

Just remember, the success of a long term trading/dealing strategy is knowing there are draw downs and losses and how and when to manage them. 

If you want to go even deeper into practical tools to help you with your risk strategy plan and building success resilience capital strategy, please check out the learn section on Wikilix. There is lots of good information to help you trade with confidence and discipline with whatever the market throws at you.