In the realm of trading, drawdown is a critical metric that quantifies the decline in an investment’s value from its peak to its subsequent trough. This measure is pivotal for traders and investors, as it provides insight into the potential risks and volatility associated with a particular trading strategy or portfolio.
The chart above shows the performance curve of one of our trading strategies (If you want to take a closer look at it, go here: TW_v4_SPY strategy). I marked a local peak and trough where you see the black horizontal lines on the right. The top line is the local peak and the bottom line is the local trough. The area in between is the drawdown. There are many drawdowns in a strategy, but only one of these will be the maximum drawdown.
Understanding Drawdown
A drawdown represents the reduction in equity from a peak to a trough during a specific period. It is typically expressed as a percentage and is calculated using the formula:
For instance, if an investment’s value decreases from $100,000 to $80,000, the drawdown is:
Maximum Drawdown (MDD)
The Maximum Drawdown is the largest observed loss from a peak to a trough before a new peak is achieved. It serves as a key indicator of downside risk over a specific period. A lower MDD suggests a more stable investment, while a higher MDD indicates greater volatility and potential risk.
Why Focusing Solely on Maximum Drawdown Can Be Misleading
While MDD provides valuable information about the worst-case scenario, relying exclusively on this metric can be deceptive. It offers a snapshot of the deepest decline but doesn’t account for the frequency, duration, or recovery time of drawdowns. Two strategies might have identical MDDs, yet one could experience frequent, shallow drawdowns, while the other suffers infrequent but prolonged declines.
A Comprehensive Approach to Drawdown Analysis
To gain a holistic understanding of a trading strategy’s risk profile, consider the following aspects:
- Drawdown Frequency: How often do drawdowns occur? Frequent drawdowns might indicate a volatile strategy.
- Drawdown Duration: How long does it take to recover from a drawdown? Shorter durations suggest quicker recovery and resilience.
- Drawdown Magnitude: Beyond the maximum, what are the average and median drawdowns? This provides insight into typical losses.
- Recovery Time: How long does it take to return to the previous peak after a drawdown? Shorter recovery times are preferable.
Case Study: TW_v4_SPY Strategy
The TW_v4_SPY strategy, trading the SPDR S&P 500 ETF (SPY), offers an illustrative example. Over a 15-year backtest, the strategy achieved a cumulative return of 40,937% with an annualized return of 46.3%. Its maximum drawdown was 27.01%, slightly higher than SPY’s 25.33%. However, a deeper analysis reveals that the strategy’s drawdowns are typically more muted and shorter-lived compared to SPY. Notably, SPY’s drawdowns were greater than those of the TW_v4_SPY strategy 68.9% of the time, indicating the strategy’s resilience during market downturns.
Visualizing Drawdown Dynamics
To effectively assess a strategy’s risk, it’s beneficial to visualize drawdown patterns. Charts depicting drawdown over time can highlight periods of significant decline and recovery, offering a clearer picture of the strategy’s performance under various market conditions.
Relative Drawdown
However, the best way to compare the drawdown performance of two competing strategies is a relative drawdown analysis. Here below we see it done between our TW_v4_SPY strategy and the SPY (buy and hold). Identifying the relative drawdown performance and comparing the size of each strategy’s relative drawdown area (where each of the strategies is performing worse) allows an easy, yet comprehensive drawdown comparison that is far superior. It should be the gold-standard of drawdown analysis and replace the MaxDD metric publicized with every trading strategy.
Conclusion
While Maximum Drawdown is a valuable metric, it should not be the sole determinant in evaluating a trading strategy’s risk. A comprehensive drawdown analysis, considering frequency, duration, magnitude, and recovery time, provides a more nuanced understanding of potential risks. By adopting this holistic approach (aka relative drawdown), traders and investors can make more informed decisions, aligning their strategies with their risk tolerance and investment objectives.
