What is maximum drawdown?

You will often come across the term 'maximum drawdown' when reading about forex trading and if you are to have any chance of not losing your entire account then it is essential that you have an understanding of what it is all about, which is exactly what this article will explore.

Your maximum drawdown can be defined as the amount by which your account has fallen in value relative to the highest value that was previously attained (see Graph 1). It is calculated by subtracting the value at any given point from the highest value that occurred prior to the value you are subtracting. Unless you have discovered a way of peering into the future, you will inevitably at some time or another experience one or more trades that lose you money. The more that you risk on each trade and the more consecutive losing trades that you experience, the larger your drawdown will be. Why do you care? Because the larger your drawdown is, the more difficult it is to recover your account to its previous value and the greater the risk of ruin.

For example, take a look at the next graph below (Graph 2). We have three different traders, Mr Black, Mrs Blue and Dr Red. After 16 or so trades, Mr Black has lost 10% of his account. To recover his account to the starting value, he will need to make approximately 11% of his current account's value. Mrs Blue lost 25% of her account and she will need to make approximately one third of her current account's value to return to her starting balance. Dr Red, however, lost half of his account. In order to return to his original starting balance (break even) he will need to make a whopping 100% of his current account's value (in other words he will need to double his account). Adding 11% value is achievable. Adding 100% would be a monumental feat.

So, a primary consideration for any new strategy you develop is to try and minimise the degree of drawdown that you might expect. Obviously you can never predict this with total accuracy, but with backtesting over a sufficiently long period, you can make a reasonable guess at the sort of drawdown you could experience. As an example, if we look at Graph 1 once more, we can see that if you had backtested your strategy only on the period after trade #13, you might have seen a maximum drawdown of maybe 2% (between trade #17 and #18), falsely giving you the impression that this strategy would produce very low drawdowns. Alternatively, if you had only backtested the period between trade #3 and #11, you may well discard the strategy as being totally unprofitable, producing an overall loss. So, the greater the period of time that you can backtest your strategy on, the better. As we can see, if we take the whole period of the graph into account, we have a maximum drawdown of 15%, but an overall profitable strategy. This sort of analysis can influence your decision about the size of position you wish to take for trades on certain strategies.

Clearly the lower the amount that you risk on each trade, the lower your drawdowns will be, but you have to balance this with profitability. Ideally you want to strike a balance where you have acceptable levels of drawdown to minimise your risk of ruin, but which still allow you to make as much profit as possible from each strategy. To illustrate this point, the final graph displayed here (Graph 3) shows the same hypothetical strategy run with three different position sizes.

The black line had the smallest position sizing, had a maximum drawdown of 23% and made 16% overall. The blue line risked more on each trade, had an unwanted 45% maximum drawdown (which in reality would be very hard to recover from), but made 32% overall. The red line, whilst it looks like the most profitable at the end having gained 62%, actually would not have made it that far as its maximum drawdown was 92%, effectively destroying the account.