Drawdown

Drawdown is a fundamental risk metric in trading that measures the reduction in capital or equity from a previous peak. It is used to evaluate the risk profile of a given trading strategy, as deep drawdowns can create severe psychological and financial hurdles to recovering capital.

Drawdown is calculated using the following formula: Drawdown Percentage = ((Peak Value - Subsequent Trough Value) ÷ Peak Value) × 100

There are two primary types of drawdown:

• Current Drawdown: The difference between the most recent peak and the current value.
• Maximum Drawdown (MDD): The largest peak-to-trough drop recorded historically in the account.

Monitoring drawdown is crucial because it helps traders assess their risk tolerance. The larger the drawdown, the greater the gain required to restore the initial capital; for instance, a 50% loss requires a 100% gain just to break even. Common mistakes include ignoring historical drawdown when choosing a trading strategy, or maintaining the same position sizing after experiencing a substantial drawdown without re-evaluating the approach, which can ultimately lead to a total account wipeout.