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Max drawdown and recovery

Define max drawdown, compute it from an equity curve, and explain why it's the most psychologically real risk metric.

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Options, Risk Math, and Psychology

Risk Math Deep Dive

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Lesson 42 of 75Options, Risk Math, and PsychologyRisk Math Deep Dive

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Define max drawdown, compute it from an equity curve, and explain why it's the most psychologically real risk metric.

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Drawdown: the biggest fall from a high

Max drawdown is the biggest peak-to-trough decline in your account's history. To compute it: track the running peak of your equity curve. At every point, compute (peak − current) / peak as a percentage. The highest value that ratio ever hits is your max drawdown. If your $500 account climbed to $700 and then fell to $490 before recovering, the peak was $700 and the trough was $490. Drawdown = ($700 − $490) / $700 = $210 / $700 = 30%.

Wick points at a practice chart that falls from a $700 peak to a $490 low before turning up, showing max drawdown is measured from the peak, here 30%.Drawdown: 30%Practice chartLow $490Fall from $700
Wick saysDrawdown is the drop from your highest point: $700 down to $490 is 30%.

Why max drawdown is the most psychologically real risk metric. Returns and Sharpe describe an average. Drawdown describes the worst moment you actually lived through. That's the moment you decide whether to keep trading or quit. A strategy with great Sharpe but a 60% drawdown gets abandoned by 90% of people. A strategy with okay Sharpe and a 15% drawdown gets stuck with. Survivability and consistency matter more than peak return.

Wick checks a meter labeled your drawdown limit, with under 20% in the calm zone and 50% or more in coral, teaching you to know your pain number before it tests you.Under 20%50% or moreYour drawdown limit?
Wick saysMost traders can stand about 20% drawdown. Almost nobody handles 50% calmly.

Two metrics professionals pair with drawdown. First, time-under-water — how long the drawdown lasted from peak back to new peak. A 20% drawdown that recovers in two months is very different from one that takes two years. Second, the Calmar ratio — annual return divided by absolute value of max drawdown. Calmar greater than 1 means your annual return exceeds your worst drawdown. Calmar greater than 2 is institutional-grade. Calmar greater than 3 in a backtest, like Sharpe, is probably too good to be true.

Wick points at a chalkboard showing Calmar as yearly return divided by max drawdown, above 1 is good, showing how pros pair return with the worst drop.Calmar ratioYearly return÷ max drawdownAbove 1 is good
Wick saysCalmar compares your yearly return to your worst drop. Above 1 is a good sign.

Recap: max drawdown = biggest peak-to-trough drop, as a percentage. It predicts whether you'll quit. Pair it with time-under-water and Calmar. Know your personal pain threshold BEFORE you trade.

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1. Your $500 account climbs to $800, falls to $600, climbs to $900, falls to $720, climbs to $1,000. What's your max drawdown?

2. Why do institutional allocators often weight max drawdown more heavily than Sharpe ratio?

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