Maximum Drawdown (MDD) measures the largest peak-to-trough decline in your portfolio before a new peak is reached. It's perhaps the most important risk metric for understanding the worst-case scenario of your strategy.
Reality Check: Maximum drawdown tells you how much pain you'll experience with a strategy. If you can't stomach a 30% drawdown, don't trade a strategy that shows one in backtesting.
The Formula
Max Drawdown = (Trough Value - Peak Value) / Peak Value × 100 Example: Portfolio peak: ₹1,50,000 Portfolio trough: ₹1,05,000 Max Drawdown = (1,05,000 - 1,50,000) / 1,50,000 = -30%
Why Drawdown Matters More Than Returns
The math of recovery is brutal:
| Drawdown | Recovery Needed | Difficulty |
|---|---|---|
| 10% | 11% | Easy |
| 20% | 25% | Moderate |
| 30% | 43% | Hard |
| 50% | 100% | Very Hard |
| 75% | 300% | Nearly Impossible |
Key Insight: A 50% loss requires a 100% gain just to break even. This is why protecting against large drawdowns is crucial.
Acceptable Drawdown Levels
| Risk Tolerance | Max Drawdown | Typical Investor |
|---|---|---|
| Conservative | Below 10% | Retirees, capital preservation |
| Moderate | 10-20% | Most investors |
| Aggressive | 20-30% | Experienced traders |
| Very Aggressive | Above 30% | High-risk speculators |
The Psychology of Drawdowns
Backtesting shows numbers, but you'll feel every drawdown:
- 10% drawdown: "Normal market fluctuation"
- 20% drawdown: "Getting uncomfortable"
- 30% drawdown: "Did I make a mistake?"
- 40% drawdown: "I need to stop the bleeding"
- 50% drawdown: "I'm never trading again"
Expect Worse: Your actual worst drawdown will likely be larger than what backtesting shows. Markets can always surprise you.
Managing Drawdowns
1. Position Sizing
Smaller positions = smaller drawdowns. Risk only 1-2% per trade.
2. Stop Losses
Limit individual trade losses to prevent portfolio destruction.
3. Diversification
Don't put all capital in one strategy or one stock.
4. Maximum Loss Rule
Stop trading if portfolio drops 20-25% and re-evaluate.
Rule of Thumb: Your maximum position size should be such that if the trade hits your stop loss, you lose at most 1-2% of total capital.
In VivaTrades
VivaTrades shows Maximum Drawdown for every backtest. Always check this metric and ask yourself: "Can I handle this level of loss emotionally and financially?"
- If drawdown is too high, consider tighter stop losses
- Reduce position size to lower overall drawdown
- Add filters to avoid bad trades