The Maximum Drawdown

27 9 2014 - No comment

The Maximum Drawdown or the Max Drawdown for those in the know, is a quality indicator for trading and risk management

To improve your trading, you must be able to analyse the quality of your trading. The Profit Factor coupled with the Maximum Drawdown will give you an “honest” statistical view of the quality of your trading. Of course, you must put this into perspective with your objectives and psychological feelings. You can earn money, have a good Drawdown and Profit Factor and yet know that you did not trade well because you took too much leverage, you almost broke down … which these indicators cannot tell you, only you can feel your own trading.

Definition of Maximum Drawdown

Maximum Drawdown means the historic maximum loss an unlucky investor would suffer if he buys high and sells low during a specified period. This is one of the instruments used by hedge funds to assess traders. If a trader makes money but has a max drawdown of -20% for example, he will leave straight away.

How to calculate the Max Drawdown

It is very simple, you must identify your maximum loss in a day, a week, a month, or a year … I calculate my max drawdown daily, then recalculate it for the week, month etc.

Concrete examples of Max Drawdown

Example 1, 4 trades in the day:

Trade 1: €+50

Trade 2: €-21

Trade 3: €+5

Trade 4: €+15

Simple, your Max drawdown is €-21.

If you have €1,000 of capital you can calculate in % (21/1000) * 100 = 2.1. Your Max Drawdown for the day is -2.1% of your capital. (Incidentally, I give my Max Drawndown in euros on my stock market blog because in this way you cannot calculate the cash value of my portfolio ;)).

Example 2, 8 trades and it gets complicated:

Trade 1: €+12

Trade 2: €+30

Trade 3: €-33

Trade 4: €+5

Trade 5: €-10

Trade 6: €+20

Trade 7: €+35

Trade 8: €-25

What is the Max Drawdown?

€-33? Fail… It is €-38. This is crazy; it’s not €-38

And yes the Max Drawdown is the historic maximum loss, not the trade that generated the highest loss (nuance).

So in this example, in trade 3, the Max Drawdown is €-33,

Trade 4 at €+5 gives us a drawdown of €-28 (this is no longer the max) (-33 + 5 = 28)

Then we identify €-10 in trade 5 which makes a Max Drawdown of €- 38 (-28 -10 = -38), the Max drawdown at €-33 is the past,

Trade 6 at €+20 gives us a drawdown (not max) of €-18,

The 7th trade of €+35 gives us a Drawdown of 0 (-18 + 50 = 32) because the drawdown is zero-based and can only be negative.

The last trade at €-25 directly gives us a drawdown of €-25 which can become max if the next trade 9 is €-15 for example (= -25-15= -40)

The Maximum Drawdown and risk management

The maximum Drawdown is therefore a little mean. It does not spare you. You can make 50 winning trades, but it waits for you around the corner. If you go on with bad trades, they can accumulate … and the Maximum Drawdown continues to increase without the possibility of ever dropping. Even if you could then trade like a god, the Maximum Drawdown will always be there to tell you: “yes this is my guy, but you have made a historic loss of € xxx or x%, you can always show off.” It is an indelible mark…

My vision of the Max Drawdown

The Maximum Drawdown is therefore an instrument to determine the quality of an investment, a formidable addition to the Profit Factor. Of course, no investment fund promotes the Maximum Drawdown, we would be greatly surprised.

Thus, a +51% increase can be displayed on a product (Wahouu, great, I will put my money on it). But if it has a max drawdown of -17%, and you are unlucky and buy it high, you can also lose -17%. (And if the future is like the past of course, but that does not happen).

Conversely, an investment at +15% with a max drawdown of -2% is much more interesting, you are risking -2% maximum to win +15% maximum.

Another example; in the month of September, I earned €7,247 for a max drawdown of €-135, it was rather a good risk.

It is the most ruthless quality instrument of trading (and also risk management) in existence. You can trade for 259 days to perfection, and commit several errors once in the year. This little pest will be there to remind you about it throughout the year, and this is what traders dread.

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