Maximum Drawdown: Definition, Calculation and Risk Rules
In this article
Maximum drawdown (MDD) is the largest observed percentage decline in account equity from a historical peak to a subsequent trough over a given period. It is a key downside risk metric that shows the largest historical erosion of capital during that period.
This risk metric measures the largest peak-to-trough decline in an account, portfolio or trading strategy over a chosen period. It shows how far the value fell from a previous high before recovering or reaching the end of the observation period.
Unlike profit or win rate, MDD focuses on downside risk. It can help you assess how much volatility and loss your strategy has experienced, whether your position sizing is sustainable and how vulnerable your account may be to further losses when leverage is involved.
Quick Takeaways
- MDD measures the largest observed decline from a previous peak to a subsequent trough.
- Recovering from a drawdown is mathematically asymmetric: a 50% decline requires a 100% gain to return to the previous peak.
- A historical MDD figure is a useful risk benchmark, but it does not set a limit on future losses.
- For leveraged trading, equity-based drawdown can reveal risks that a closed-balance calculation may miss.
What Is Maximum Drawdown in Trading?
MDD is a measure of downside risk. It identifies the largest decline from a previous high to the lowest subsequent value over the period being analysed.
A drawdown begins when an account falls below a previous peak. It ends when the account reaches a new high. If the account has not recovered by the end of the measurement period, the decline can still be included when assessing its current drawdown.
Drawdown terminology can vary between platforms and analytical tools, so it's worth checking how your particular report calculates each metric.
MetaTrader 5, for example, distinguishes between several balance-based measures:
- Balance Drawdown Absolute: The difference between the initial deposit and the lowest balance recorded below that initial deposit.
- Balance Drawdown Maximal: The largest monetary decline from a local balance high to the next local low.
- Balance Drawdown Relative: The largest percentage decline from a local balance high to the next local low.
These platform-specific definitions should not be assumed to apply to every performance-reporting system.
For a broader explanation of drawdowns and how they affect a trading account, see what is drawdown in trading.
How Is Maximum Drawdown Calculated?
To calculate MDD as a percentage, identify each relevant peak and its subsequent trough, calculate the percentage decline and then select the largest result.
Maximum Drawdown (%) = ((Peak Value − Trough Value) / Peak Value) × 100
Consider a trading account that starts with $10,000:
- The account rises from $10,000 to $15,000 — Peak 1.
- It then falls to $9,000 — Trough 1.
- The account recovers and reaches $18,000 — Peak 2.
- It then falls to $14,000 — Trough 2.
The two drawdowns are:
First Drawdown
From $15,000 to $9,000:
- Monetary decline: $15,000 − $9,000 = $6,000
- Percentage decline: ($6,000 / $15,000) × 100 = 40%
Second Drawdown
From $18,000 to $14,000:
- Monetary decline: $18,000 − $14,000 = $4,000
- Percentage decline: ($4,000 / $18,000) × 100 = 22.2%
The first decline is larger in percentage terms, so the maximum decline for the period is 40%.
This example also shows why comparing drawdowns only in monetary terms can be misleading. The size of the account at the peak matters when assessing the percentage decline.
Why Drawdown Recovery Is Asymmetric
Recovering from a drawdown requires a larger percentage gain than the percentage originally lost. This happens because the recovery return is calculated on a smaller capital base.
Drawdown | Balance From a $10,000 Peak | Gain Required to Recover |
|---|---|---|
10% | $9,000 | 11.1% |
20% | $8,000 | 25.0% |
30% | $7,000 | 42.9% |
50% | $5,000 | 100.0% |
70% | $3,000 | 233.3% |
90% | $1,000 | 900.0% |
After a 10% drawdown, an account needs an 11.1% gain to return to its previous peak. After a 50% drawdown, the remaining capital must double, requiring a 100% gain.
Deep drawdowns therefore make recovery increasingly difficult. They do not mean a trader has to take more risk, but attempting to recover quickly by increasing position sizes can expose the remaining capital to even larger losses.
Floating Equity vs Closed Balance
A trading account's balance and equity do not necessarily show the same level of risk.
The balance does not include floating profit or loss from open positions, while equity reflects the current value of those open positions. MetaTrader 5, for example, includes floating profit or loss when calculating equity.
This distinction matters when measuring drawdown.
An account may show only a modest decline in its closed balance while open positions are carrying substantial floating losses. Looking only at balance can therefore understate the account's current exposure.
If those floating losses reduce available funds far enough, the broker may close positions automatically under its margin rules. For UK retail CFD accounts, rules from the Financial Conduct Authority (FCA) require firms to close out positions when the client's funds fall to 50% of the margin required to maintain the open positions. Retail clients also receive negative balance protection under these rules.
Leverage can make this risk more significant. Because a leveraged CFD allows a trader to take market exposure that is larger than the margin posted, a relatively small adverse price movement can have a much larger effect on account equity.
The FCA stated in December 2022 that approximately 80% of customers lose money when investing in CFDs. FCA rules also require CFD providers to display a standardised risk warning showing the proportion of their own retail client accounts that lose money.
For this reason, equity-based drawdown is particularly useful when assessing the risk of strategies that regularly hold leveraged positions open.
Common Drawdown Pitfalls
This metric is only useful once you understand its limitations.
Treating Historical MDD as a Future Loss Limit
Historical maximum drawdown shows the largest decline recorded during the period being analysed. It does not predict the largest drawdown that could happen in the future.
Different market conditions, price gaps, unusually high volatility or reduced liquidity can produce a larger decline than anything seen in historical data.
Increasing Risk to Recover Losses
If you increase your position size after a losing run, it may feel like a shortcut back to breakeven, but it also increases the capital you have exposed when recent performance is already weak.
This type of revenge trading can turn a manageable drawdown into a much larger one.
Ignoring Correlated Positions
Holding several positions does not necessarily mean an account is well diversified.
For example, long positions in both EUR/USD and GBP/USD can create concentrated exposure to movements in the US dollar. If correlated positions move against the trader at the same time, losses can accumulate across several trades.
Correlation is not constant, so the level of combined exposure should be assessed rather than assuming that each position represents an independent risk.
Treating a Fixed Risk Percentage as a Universal Rule
You might set a maximum amount of equity you're willing to risk on each trade, such as 1% or 2%. These figures are common examples rather than universal rules.
An appropriate limit depends on factors including the trader's risk tolerance, strategy, account size, expected volatility and use of leverage.
Actual losses can also exceed an intended risk amount in some market conditions, for example if a price gaps beyond a stop level.
How Can Maximum Drawdown Support Risk Management?
MDD gives you a useful historical benchmark for assessing the downside of your trading strategy.
For example, it can help you answer questions such as:
- How much did the strategy lose from its previous peak?
- How difficult would that drawdown have been to recover from?
- Is the historical drawdown consistent with the trader's risk tolerance?
- Would higher leverage or larger position sizes make the strategy too vulnerable?
- Does the calculation include floating equity or only closed trades?
This figure should not be considered in isolation. A strategy with strong returns may still involve an uncomfortable level of drawdown, while a strategy with a relatively low historical drawdown can still experience larger losses in different market conditions.
Position sizing, overall account exposure, correlation between trades and the use of leverage all affect how quickly a drawdown can deepen.
For a broader framework covering these controls, see what is risk management in trading.
Maximum Drawdown: Key Point
Maximum drawdown shows the largest historical decline from a previous peak to a subsequent trough. It is useful for comparing downside risk, understanding the difficulty of recovering from losses and assessing whether a trading strategy's risk profile is sustainable.
However, it is a backward-looking measure. A historical MDD reading does not place a ceiling on future losses, particularly when leverage, market gaps and changing liquidity conditions are involved.
FAQ
What Is a Good Maximum Drawdown Percentage in Trading?
There is no universally ‘good’ maximum drawdown percentage. An acceptable level depends on the trading strategy, volatility, use of leverage and the trader’s risk tolerance. In general, a lower drawdown means less capital needs to be recovered, while deeper drawdowns require increasingly larger percentage gains to return to the previous peak.
What Is the Difference Between Maximum Drawdown and Absolute Drawdown?
Maximum drawdown measures the largest decline from a previous peak to a subsequent trough over the period being analysed. Absolute drawdown generally measures how far the account falls below its initial capital. Definitions can vary between reporting platforms, so traders should check the methodology being used.
Does Maximum Drawdown Include Open Floating Trades?
It depends on whether the calculation uses balance or equity. An equity-based drawdown includes unrealised profit and loss from open positions, while a balance-based calculation generally reflects closed trading results. Equity-based drawdown can therefore provide a clearer view of risk when leveraged positions remain open. For UK retail CFDs, falling equity can also affect margin requirements. FCA rules require firms to close out positions when a client’s funds fall to 50% of the margin required to maintain their open CFD positions.
Why Does a 50% Drawdown Require a 100% Gain to Break Even?
Drawdown recovery is asymmetric because percentage gains are calculated from the remaining capital. After a 50% drawdown, only half of the previous equity remains. That remaining amount must therefore double — a 100% gain — to return to the previous peak.
Is Past Maximum Drawdown a Limit for Future Losses?
No. Historical maximum drawdown shows the largest decline recorded during the period analysed, but it does not set a limit on future losses. Different volatility, market gaps, reduced liquidity, changes in position sizing or greater leverage can result in a larger future drawdown.
