Maximum Drawdown (MDD)
ES: Máxima Caída Acumulada (MDD) PT: Drawdown Máximo
The metric that captures a strategy’s worst historical scenario: the largest decline from a peak to the subsequent trough. Its arithmetic is merciless, because recovering demands a return far greater than the fall suffered.
What Maximum Drawdown Is
Maximum drawdown is the largest percentage decline of a portfolio from a historical peak to the subsequent trough, before reaching a new peak. Its formula is (peak − trough) / peak × 100.
An example: a portfolio that reaches 120,000, falls to 90,000 and then recovers has a maximum drawdown of (120,000 − 90,000) / 120,000 = 25%.
It is a critical metric because it captures the worst real experience of trading a strategy: the moment of maximum psychological suffering, which is exactly when most people quit.
Its defining feature is the asymmetry of recovery: recovering always demands a larger percentage than the fall. A 10% decline needs an 11.1% rise; 20% needs 25%; 50% needs 100%; and 75% needs 300%. That asymmetry explains why surviving matters more than maximising returns: protecting capital during drawdowns preserves the mathematics of compounding.
There are four types of measurement: realised, the worst decline actually suffered; intraday, measuring the low within the session; absolute, the total decline from the peak; and time under water, measuring how long the portfolio stays below its previous peak.
Typical values vary widely: a buy-and-hold equity index reached −57% in 2008 and −34% in 2020; hedge funds usually run between −10% and −30%; long-term value strategies between 20% and 40%; managed futures between 15% and 25%; and market-neutral strategies between 5% and 15%. A lower maximum drawdown usually comes with lower returns, but a superior risk-adjusted result.
The Arithmetic of Recovery
The impact of drawdowns on compounding is devastating and enormously underestimated. The formula for the return needed to recover is 1 / (1 − drawdown) − 1.
The full table is stark: a 10% decline requires an 11.11% rise; 20%, 25%; 30%, 42.86%; 40%, 66.67%; 50%, 100%, that is doubling; 60%, 150%; 70%, 233%; 80%, 400%; and 90%, 900%, practically impossible.
Three implications follow. Large drawdowns seriously compromise compound growth: even if the capital is recovered, years of compounding are lost. Strategies with smaller drawdowns may lag in bull markets but preserve capital to compound across the whole cycle. And recovery usually takes much longer than the fall: the 2008-2009 collapse meant −57% over eighteen months and needed more than five years to mark a new high.
Duration is the indispensable complementary metric. Most traders psychologically tolerate a 20% drawdown for three to six months; past a year below the previous peak, almost everyone abandons the strategy however theoretically sound it is.
The combined effect explains a counterintuitive comparison: a portfolio with a 30% annualised return and a 60% maximum drawdown demands exceptional discipline to hold, while one at 15% annualised with a 20% drawdown offers a better risk-adjusted result and, above all, a sustainable one. That is what lies behind Buffett’s rule about not losing money: it is not a literal target of zero losses, but a recognition of this arithmetic.
The Calmar Ratio
The Calmar ratio combines return and drawdown into a single risk-adjusted measure: Calmar = annualised return / maximum drawdown.
Two examples: a strategy at 20% annualised with a 10% drawdown gives a Calmar of 2.0; another at 30% annualised with a 40% drawdown gives 0.75. The first is superior despite returning less in absolute terms.
Its interpretation is tiered: above 3 is exceptional and typical of elite funds; 2 to 3 is excellent and professional grade; 1 to 2 is a good strategy for a retail trader; 0.5 to 1 is marginal, where most index portfolios fall; and below 0.5 the risk-adjusted return is poor.
Against the Sharpe ratio, the difference is what is used as the risk measure: Sharpe uses volatility and Calmar uses maximum drawdown, which fits the real experience of trading far better. Many strategies with similar Sharpe ratios have very different Calmar ratios, which is why funds increasingly report both.
Variants exist such as the Sterling ratio, which uses the average drawdown across several periods and penalises a single catastrophic episode less heavily.
The underwater curve — plotting the distance from the peak over time — completes the analysis and reveals three things: how often drawdowns occur, how long they take to recover, and how dispersed they are. A flat curve indicates a stable strategy; a deep and prolonged one, a vulnerable strategy.
In portfolio construction, institutional managers usually set a drawdown budget — not exceeding 15%, for instance — and that constraint conditions the entire allocation. The retail investor would do well to adopt the same discipline: decide what drawdown they can tolerate and build the portfolio accordingly.
Managing Drawdowns
Management is as much mental as operational.
On the psychological side there are five measures. Expect them: every strategy will suffer them, and you must prepare mentally before they arrive. Set response rules in advance: decide what to do at each level, for example cutting size 25% at 10%, pausing and reviewing at 15%, and requiring an external review at 20%. Avoid revenge trading, that temptation to recover fast with aggressive trades, which is always destructive. Keep a log throughout the drawdown, documenting your emotional state and any deviations from the plan. And look after your physical health, because rest and exercise directly affect decision quality.
On the operational side there are five more. Reduce positions at predefined thresholds. Pause the strategy if the drawdown exceeds 20% or 30%, which may indicate it has stopped working in the current regime. Compare against history: if the drawdown is within the expected range, persist; if it exceeds it, investigate the cause. Detect regime changes, because strategies designed for one environment fail in another. And prioritise capital preservation over loyalty to the strategy when the account’s viability is at stake.
On recovery, the most common error is trading aggressively to win back what was lost. The correct approach is exactly the opposite: return to normal size, maintain discipline and trust the arithmetic. A 10% drawdown recovers in about eight months at a 15% annual return; trying to accelerate it usually prolongs the drawdown or creates a larger one.
Drawdowns and Options
In options, maximum drawdown carries its own considerations.
Options portfolios suffer far larger drawdowns than equity portfolios because of leverage and gamma exposure. A naked short position can exceed 100% loss on a single trade, and even defined-risk structures can accumulate monthly drawdowns of 20% to 40%.
In long options, maximum drawdown is capped at the total premium at risk. If you hold several positions, the aggregate drawdown is the sum of the premiums, and sizing must account for it: 1% of risk across ten positions equals a 10% maximum portfolio drawdown.
Credit spreads and iron condors have a paradoxical profile: many small wins and the occasional large loss. Ten months collecting 100 produce 1,000 of profit, and one maximum loss can take half of it. The result is still positive, but the drawdown feels far larger than it is.
Gamma risk deserves separate mention: positions become increasingly sensitive as expiration approaches, and a weekly option can swing 50% to 100% in a single session.
That said, options can also be used to reduce maximum drawdown. Buying protective puts on an index portfolio caps the drawdown at around 15% against a potential above 50% unhedged, at an annual cost of 1% to 3% in premiums. Collars define it precisely in exchange for capping the upside too.
The sizing rule is clear: simulate each strategy’s expected maximum drawdown and limit its weight so that portfolio-level drawdown does not exceed your set tolerance. If a strategy shows a 25% maximum drawdown and is allocated 40% of the portfolio, portfolio-level drawdown will be 10%.
Maximum Drawdown by Strategy Type
It varies enormously: choose an approach whose drawdown you can genuinely tolerate.
| Strategy | Typical maximum drawdown | Recovery time | Usual Calmar |
|---|---|---|---|
| 5-15% | 3-12 months | 1.5-3.0 | |
| 15-25% | 6-18 months | 0.8-1.5 | |
| 15-30% | 12-24 months | 0.6-1.2 | |
| 25-50% | 24-60 months | 0.3-0.8 | |
| 30-60% | 36-72 months | 0.2-0.6 | |
| 40-80% or more | Variable | Frequently negative |
Frequently Asked Questions
What maximum drawdown is acceptable?
The key is matching tolerance to real psychological capacity, not the desired one. Someone who cannot withstand a 30% drawdown will abandon the strategy at the worst moment and miss the recovery.
Which is why a strategy with a 15% drawdown you can actually hold is always preferable to one with 35% you will end up abandoning.
What is the difference between maximum drawdown and volatility?
A strategy can have high volatility without large drawdowns, and another low volatility with occasional very deep episodes. An example: one with 15% annual volatility might have a 20% maximum drawdown, while another with only 10% volatility might suffer 30% drawdowns concentrated in isolated episodes.
The Calmar ratio uses maximum drawdown and Sharpe uses volatility. The real experience of trading resembles the first far more closely: losses are felt viscerally, not as theoretical standard deviations.
How do I reduce my portfolio’s maximum drawdown?
There is an unavoidable trade-off: a lower maximum drawdown usually means lower returns. Optimising the Calmar ratio rather than absolute return produces better risk-adjusted results.
What is the underwater curve?
A shallow, brief curve indicates a healthy strategy; a deep and prolonged one is cause for concern. Several overlapping drawdowns suggest the strategy does not fit the current market regime.
It is one of the most useful visualisations for evaluating a strategy over the long run, and professional investors devote as much time to it as to return analysis.
Do options increase maximum drawdown?
But they also allow it to be reduced. Protective puts on a portfolio cap the drawdown in exchange for the premium cost, and collars define the exposure range precisely.
They are therefore a double-edged tool: whether they reduce or inflate maximum drawdown depends entirely on the discipline with which they are used.