Last Updated on August 3, 2022
Why is max drawdown in trading important? Why should you spend time thinking about what is a good drawdown percentage?
Max drawdown is important in trading because it influences your behavior and obviously your returns. Both are dependent on each other. What is a good or acceptable drawdown percentage? There is no definite answer, but preferable as low as possible. If it gets too big, more than 25%, many traders lose hope and stop trading. Thus, 25% can serve as a heuristic for max drawdown.
In this article, we look at why you should focus just as much on drawdowns as profitability.
What is drawdown in trading?
A drawdown in trading is the percentage you are down from the latest equity peak. It’s a peak to trough decline over a certain period. If your equity is not at an all-time high, you are in a drawdown.
Most of the time the drawdown is minuscule and nothing to worry about, but when it reaches double percentage digits, the drawdown can play a significant role in your future returns. We discuss why in this article.
Drawdowns are best explained with an example:
How to calculate a drawdown in trading
Let’s assume your equity today is at a record 95 000, but over the next two months, it drops to 85 000. Your equity drops 10 000 in nominal value. The 10 000 is your drawdown.
Drawdowns are better valued in percentages. A 10 000 drawdown is 10.5% of the peak of 95 000.
Thus, the drawdown is 10.5%.
The drawdown ends when your equity sets a new peak above 95 000 and the process starts over again.
Graphical examples of drawdowns
Below is a graphical example of a drawdown in the ETF QQQ:
The first pane is the price of QQQ, while the red color in the pane below shows the percentage drawdown from the latest peak in QQQ. The drawdown above shows, for example, that the QQQ set a new high in late February 2020 before it fell to a drawdown of 27% in March. However, it quickly set a new high again in June.
Drawdowns can be lengthy. The drawdown of 27% in March 2020 is almost a drop in the bucket compared to what happened after the dot-com bubble burst in 2000:
The drawdown didn’t end until 2015! 15 years is a pretty long time to wait for a drawdown to recover. The max drawdown during this period was a hefty 83% in late 2002. This means 100 000 invested at the peak, was only worth 17 000 two years later. You need a strong character to not lose hope after such a disastrous performance.
Most traders and investors would be absolutely gutted with such a poor performance.
Why Is Max Drawdown Important In Trading?
Drawdown is very important for a trader because they play a huge impact in your compounding abilities. Huge drawdowns might force you to stop trading, it even might lead to ruin, and it makes your returns lower.
Opposite, low drawdowns can make leverage useful and make your trading scalable.
Below we have listed the main issues of why you should focus on drawdowns, preferably before they happen:
Low drawdowns limit behavioral mistakes
All things equal, a trading strategy that has the least drawdown is the most preferable. Why is that?
The reason is simple: a ton of research shows that humans are prone to commit behavioral mistakes when we are under pressure. Behavioral mistakes can be labeled cognitive mistakes that we do over and over and are a failure to think clearly which systematically deviate from logic.
Most of us have problems detaching from money, and we let money and emotions overrule our trading signals. We simply jump ship in the midst of a drawdown and let our trading strategies sail their own way.
Interestingly, we don’t jump ship when money keeps rolling in. During smooth sailing, no one thinks about losses and the next drawdown.
Almost everyone is risk-averse, for example, meaning we react more negatively to losses than to similar gains.
This is an obvious example:
If you make 100 000 per year in ten years, you would feel pretty good in all ten years. Opposite, if you make one million in year one and nothing in the next nine years, you have one excellent year and 9 miserable years. Most likely you would be much happier by making a lot less but steady gains every year.
Drawdown is much the same: we prefer a “sure” income with little volatility over a higher income but with a lot more volatility. Likewise, most traders are willing to “gamble” to avoid a loss, but react opposite when facing a potential gain.
To better understand your behavior and cognitive errors, we recommend two books:
Rolf Dobelli has written The Art Of Thinking Clearly. He describes the most common 99 mistakes we do over and over again. The book is an easy read and sometimes quite amusing.
The other book we recommend is Daniel Kahneman’s Thinking, Fast And Slow. This is a bit heavier, but Kahneman has been a pioneer within behavioral finance.
How much drawdown can you handle before you give up?
Drawdowns make you, as mentioned, jump ship. Many take a breather and pause their strategies after taking some beating in the markets, only to resume when they see the strategy has recovered.
This is obviously flawed in the long term. It makes you go around in circles. This is the exact reason why private investors do poorly in the stock market: buy the tops, sell the bottoms.
The problem is, you never know when the strategy has stopped working or if it’s just a normal cyclical downturn.
To minimize this mistake, always start by understanding the strategy you are trading. If you have no basic understanding of why the strategy should work, then obviously you have no knowledge of when it stops working. Make sure you understand the edge and have done backtests over long periods of time.
- Why trading strategies are not working (How do you know a trading strategy stops working?)
- How to avoid or minimize strategies stop working (Be prepared when your strategy stops working)
Drawdowns result in lower CAGR and compounding
The 83% drawdown in Nasdaq between 2000 and 2002 would need a 590% return to recover to the peak. That would take 12 years with a 15% return, 18 years with a 10% return, and 25 years with 7%. These simple numbers explain pretty well why it makes sense to have low drawdowns.
The lower drawdown you have, the higher level you can start compounding from:
A low drawdown equals compounding from a higher level
You don’t need to be a genius to understand that it’s better to start compounding with a capital base of 100 000 instead of 50 000. Given equal returns, you obviously make more the more capital you have.
You have to look at drawdown the same way. After each drawdown, you start compounding at a higher level.
The graph below illustrates this pretty well:
The graph has two lines: the black line shows the buy and hold of the S&P 500 (SPY) from 1993 until July 2021 (log scale), while the red line is a trading strategy part of our monthly Trading Edges. The dates are not included in the chart, but from 2000 until 2010 the S&P 500 had negative real returns while the strategy continued to perform well.
What is the main takeaway from the graph above? To minimize drawdown is important. When a trading strategy keeps you out of trouble, you can start compounding at a higher level/base.
Because the strategy keeps you out of trouble, ie. it has less drawdown than buy and hold, you can start compounding at a higher level when the dust settles. This is the main advantage of trading, in our opinion. After the GFC in 2008/09, the strategy starts at a higher level because it hardly had any drawdowns during the crisis.
For the most part of the period from 1993 to 2021, the strategy has significantly less drawdown than the buy and hold, but at the same time, it seems to keep up when the S&P 500 starts rising. This is the main reason why this strategy outperforms the buy and hold. Please keep in mind that the strategy above is only invested about one-third of the time.
The best example of drawdown and compounding happened during the Covid-19 mess in March 2020. The strategy hardly has a drawdown, but it “explodes” on the upside when the S&P 500 also bottoms. The strategy made a good job of preserving your capital while made you invest on the bottom. When the dust settled you started compounding from a higher base. The strategy preserved your capital during turbulent times.
Drawdowns can lead to ruin
To avoid ruin should be in the back of the head of any trader at all times. If your trading strategies have big drawdowns, this increases the risk of ruin if all of them turn sour at the same time.
Nassim Nicholas Taleb had a fantastic saying in one of his books:
Never cross a river that is on average four feet deep.
This applies to trading as well. If you take on a strategy that has the potential for huge drawdowns, you should be careful in implementing it. It might drown you.
Low drawdowns can take advantage of leverage
When you are trading, you are looking to exploit short-term trading edges. Because you are spending much less time in the market compared to buy and hold, and subsequently experience lower drawdowns, you can sometimes afford to use leverage.
Leverage mostly comes in two forms:
Futures trading is always based on margin because it’s a “bet” between two parties and only requires a deposit normally not higher than 10% of the value of the contract:
If you are trading ETFs, most brokers offer you margin, limited to the size of your equity (2x equity in leverage). You’ll need to pay interest on the margin.
We are not recommending leverage even though we use leverage via futures and moderate doses of margin from our brokers. Leverage always involves risk, because it backfires if you get it wrong. You have to be very careful and have a deep understanding of what you are doing.
Short-term trading is much more scalable than long-term investing. If you’re good, you can get rich in a hurry, but very few succeed, though. Opposite, long-term buy and hold requires a ton of patience, and the snowball doesn’t really accumulate until 20 years have passed.
Please read more about trading vs. investing on these two links:
Drawdowns are inevitable
We will get hit from time to time with large losses. Charlie and I, however, are quite willing to accept relatively volatile results in exchange for better long-term earnings than we would otherwise have had. Since most managers opt for smoothness, we are left with a competitive advantage that we try to maximize. In other words, we prefer the lumpy 15% to a smooth 12%.
The quote above was made by Warren Buffett, a man who needs no introduction. Buffett’s comment is important.
It’s important because many traders try to smooth strategies and end up curve-fitting instead. Unless you have a real structural edge, you have to accept that drawdown is the price you pay to get good returns in the markets.
You can reduce drawdowns via diversification (see more below), but at the end of the day, you can’t avoid drawdowns.
Drawdown in trading is inevitable and you have to accept that as a fact of life.
Furthermore, your biggest drawdown is most likely yet to come. How will you react after a big loss?
How to avoid drawdowns
The best way to smooth drawdowns is by diversification into different asset classes, time frames, and strategies. This is something we have covered in numerous articles before, and we recommend reading the strategies below at the end of this article.
As mentioned many times on this website in numerous articles, drawdown is a part of both trading and investing. To better understand why wrote an article called 180 years of stock market drawdowns.
- What is a good trading strategy?
- Why trading strategies don’t work in live trading
- Why trading strategies are not working
- How to avoid or minimize strategies stop working
- Why build a portfolio of quantified strategies
- What is the Holy Grail in trading?
- Free trading strategies
Conclusion: Why is max drawdown important in trading?
Max drawdown in trading is important in trading because it plays a major role in how you compound long-term. A drawdown can make you jump ship, or it can make a real dent in your performance. How you react to a drawdown is important, and thus make sure you understand why your trading strategies work.
A good drawdown percentage is as little as possible. Many traders stop trading when the drawdown reaches 20-25%, so you need to spare some thoughts on how you would react if you experience such a drawdown.
Always ask yourself: how will you react if you lose 25% of your equity? This is why drawdown in trading is important.