A maximum drawdown (MDD) is an indicator used to assess the relative riskiness of one strategy versus another. The MDD measures the largest peak-to-trough decline in the value of a portfolio (before a new peak is achieved). However, it's important to note that it only measures the size of the largest loss, without taking into consideration the frequency of large losses. It doesn't indicate how long it took an investor to recover from the loss, or if the investment even recovered at all.
The formula of measurment for this indicator is:
MDD = (Trough Value – Peak Value) ÷ Peak Value
As an example, let's assume an investment portfolio has an initial value of $50,000. The portfolio increases to $75,000 over a period of time, before plunging to $40,000 on the ferocious bear market. It then rebounds to $60,000 before dropping again to $35,000. Subsequently, it more than doubles to $80,000.
Using the formula we can calculate that MDD in this case is -53.33%
($35,000 – 75,000) ÷ $75,000 = –53.33%
Please note the following:
- The initial peak of $75,000 is used in the MDD calculation. The interim peak of $60,000 is not used, since it does not represent a new high. The new peak of $80,000 is also not used since the original drawdown began from the $75,000 peak.
- The MDD calculation takes into consideration the lowest portfolio value ($35,000 in this case) before a new peak is reached, and not just the first drop to $40,000.
Therefore when you are looking for a trader to follow, keep an eye out for his MDD and remember that you are looking for a low maximum drawdown since it indicates that losses were minimal.