What is Drawdown?

Usually, “drawdown” is used to refer to an investment's maximum loss in value from its peak value over a period of time. Drawdown can help you determine how risky a particular investment or fund is and whether it is suitable for you. The riskier the fund is, the bigger the possibility for value loss. Therefore, you can choose a fund with fewer drawdowns if you are worried about volatility and want a steadier investment ride.

Drawdown can also be used in trading for things like:

• Describing the difference between the balance and the equity at any given time. 
• Seeing how stable a trading strategy or model is over time. 
• Estimating how much equity capital would be needed to avoid drawdowns below certain levels.

How Is the Maximum Drawdown Calculated?

The maximum drawdown (MDD) formula:

​​MDD = (Trough Value — Peak Value) / Peak Value

The maximum drawdown can be calculated in two ways. If you want to know your maximum loss on a daily basis, you should compare daily trading prices. However, if you are more interested in long-term returns, you should compare monthly account balances.

Talking about the actual calculation process, finding the largest peak in your equity curve is the starting point for determining the MDD. After you've determined where your equity curve's highest peak is, you'll need to determine where its lowest point is. The MDD is calculated by dividing the difference between these two values by the highest point.

For instance, if account equity reaches $10,000 following a trade entry, drops to $9,500, and then rises to $10,500 later, you have a $500 (or 5%) drawdown. Note that many traders consider a lower MDD to be important because it signifies less risk.

However, while the rate of return on investment is important, it doesn't tell the whole story when it comes to risk. An investment could have a high rate of return but its value could still drop dramatically before increasing again. Investors would be subjected to increased volatility and more inclined to sell at a loss. The drawdown gives additional information to investors to help them understand how much money they would potentially lose on a specific investment.

Besides, the maximum drawdown is often used to estimate risk in a securities portfolio. A higher MDD suggests a higher risk level, while a lower MDD indicates a lower risk level. 

Let’s say that an investment fund has an average return of 10% but a maximum drawdown of -20%. It suggests that there were periods when investors might have lost 20% of their investment if they had bought at the top and sold at the bottom, even if the average annual return was good.