What Is Maximum Drawdown? (With a Worked Example)

Maximum drawdown is the largest percentage fall from a peak in your account balance to the lowest point that follows, before a new peak is reached. If your account climbed to $12,000, fell to $9,000, and only later went higher, that fall is the drawdown.

For every point in time, you track the highest balance reached so far (the "running peak"). The drawdown at any moment is how far below that peak you currently are, in percent. The maximum drawdown is simply the worst such value over the whole period.

As a formula: drawdown = (peak - current) / peak. Maximum drawdown is the largest value that expression ever takes.

Say an account moves like this, month by month: $10,000 → $12,000 → $9,000 → $11,000 → $8,400 → $15,000.

Walk it through. The first peak is $12,000. It then falls to $9,000 - a drop of (12,000 - 9,000) / 12,000 = 25%. It recovers to $11,000 (still below the old peak, so the peak stays $12,000), then falls to $8,400 - a drop of (12,000 - 8,400) / 12,000 = 30%. That 30% is deeper than the earlier 25%, and nothing later beats it. So the maximum drawdown is 30%.

Notice the final balance ($15,000) is a healthy +50% gain - but living through it meant watching the account fall 30% along the way. The end result and the worst moment are two different stories.

Total return tells you where a strategy ended up. Maximum drawdown tells you whether you could have stayed in the seat to collect it. A strategy that returns +200% but draws down 70% on the way is, for most people, untradeable - they'd have bailed at the bottom.

It's also the most honest stress test of a backtest. A gentle drawdown across varied market conditions is far more reassuring than a huge return earned through one stomach-churning plunge.

A few ways people misread drawdown:

• Confusing it with the final result. A strategy can finish up big and still have had a brutal max drawdown in the middle.
• Comparing drawdowns across different time spans. A 20% drawdown over ten years is not the same as 20% in a week.
• Ignoring how long recovery took. Two strategies can share a 30% max drawdown, but one recovers in a month and the other takes two years - very different to live with.
• Forgetting that buy-and-hold has a drawdown too. The right comparison is the strategy's drawdown against simply holding the asset over the same window.