Maximum Drawdown is defined as the peak-to-trough decline during a specific period of an investment, fund or commodity. A drawdown is quoted as the percentage between the peak and the trough and is simply the amount of money lost expressed as a percentage of a portfolio. If all the trades in the portfolio are profitable there is no drawdown.
A drawdown is measured from the time a retrenchment begins to when a new high is reached. The MDD is the maximum it lost during that specific timeframe. This method is used because a valley can’t be measured until a new high occurs. Once the new high is reached, the percentage change from the old high to the largest trough is recorded.
Without the aid of the proverbial crystal ball, traders will inevitably have one or more losing trades. The more that is risked on each trade and the more consecutive losing trades experienced the larger the drawdown. This is important to understand because the larger the drawdown, the more difficult it is for an account to recover its previous value and the greater the risk of ruin.
Real Life Example of Maximum Drawdown
In October 2007 the SPY (an S&P ETF) hit a high of 157. By March 2009 it made a low of 61, a 57% drop. This means that with a strategy (or algorithm) that went long only the SPY from January 1, 2007, to today, the MDD was 57%.
Another way to define MDD is the amount by which an account has fallen in value relative to the highest value that was previously attained. In this case, if you bought 100 shares of SPY in October 2007, it would have cost $140,000. By March 2009 the value of your investment would have fallen to $61,000. Your account would be underwater by a hefty $79,000. Not many could live through this kind of loss.
MDD and Time Frame
It is also important to understand the length of time a backtest should encompass. For example and backtesting only from January 1, 2009, to October 2012, the MDD becomes a lot smaller, less significant, and it misses the 57% haircut the SPY (and the whole market) took in late 2008 and 2009. There are many drawdowns but there can only be one MAX drawdown (MDD) during the specific time frame of a backtest. If you tested a smaller timeframe – say from January 1, 2009, to January 1, 2012 – the MDD would have been quite different.
It’s impossible to predict a MDD in the future, but with backtesting over a sufficiently long period, a reasonable estimation can be made of the drawdown going forward. Trading is a game of probabilities and backtesting defines these probabilities with a fairly precise measure.
How QiT uses MDD
QiT places a great deal of emphasis on minimizing the drawdown within the backtesting timeframe and, other than the CAR, is the most important metric we look at. With that said, please understand you should not define a portfolio by its MDD only. You need to look a the MDD in relation to all the other drawdowns.
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