Maximum Drawdown

Maximum Drawdown (Max DD) is the ultimate measure of historical portfolio risk. It calculates the largest single drop from a peak to a trough in your portfolio’s value before a new peak is achieved. Max DD tells you exactly how much capital you would have lost if you bought at the absolute top of the market and sold at the absolute bottom.

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The Mathematical Formula

Maximum Drawdown is calculated by finding the lowest portfolio value (trough) following a historical high (peak): $\text{Max DD} = \frac{\text{Trough Value} - \text{Peak Value}}{\text{Peak Value}} \times 100$

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Why Max Drawdown Matters

Drawdowns are asymmetric. The mathematics of recovery mean that the deeper your drawdown, the exponentially harder your portfolio has to work just to break even.

• A 10% drawdown requires an 11.1% gain to recover.
• A 20% drawdown requires a 25% gain to recover.
• A 50% drawdown requires a 100% gain to recover.

By auditing the Max DD of a backtest, you can ensure that the strategy’s worst-case scenario aligns with your psychological risk tolerance. If a backtest shows a 40% Max Drawdown, but you know you would panic and liquidate your account at -20%, the strategy is fundamentally incompatible with your risk profile, regardless of its total historical return.