The drawdown is the measure of the decline from a historical peak in some variable (typically the cumulative profit or total open equity of a financial trading strategy).
The average drawdown (AvDD) up to time is the time average of drawdowns that have occurred up to time :
The maximum drawdown (MDD) up to time is the maximum of the drawdown over the history of the variable. More formally, the MDD is defined as:
![{\displaystyle D(T)=\max \left[\max _{t\in (0,T)}X(t)-X(T),0\right]\equiv \left[\max _{t\in (0,T)}X(t)-X(T)\right]_{+}}](https://wikimedia.org/api/rest_v1/media/math/render/svg/6b25f2777a9fed4ae5eb5c12ded1927c135c4bb4)
![{\displaystyle \operatorname {MDD} (T)=\max _{\tau \in (0,T)}D(\tau )=\max _{\tau \in (0,T)}\left[\max _{t\in (0,\tau )}X(t)-X(\tau )\right]}](https://wikimedia.org/api/rest_v1/media/math/render/svg/86505fc062d808e26fc4879c34b97fc5cedcaa1b)
Trading definitions
There are two main definitions of a drawdown:
1. How low it goes (the magnitude)
Putting it plainly, a drawdown is the “pain” period experienced by an investor between a peak (new highs) and subsequent valley (a low point before moving higher).
Next, the Maximum Drawdown, or more commonly referred to as Max DD. This is pretty much self explanatory, as the Max DD is the worst (the maximum) peak to valley loss since the investment’s inception.
In finance, the use of the maximum drawdown as an indicator of risk is particularly popular in the world of commodity trading advisors through the widespread use of three performance measures: the Calmar ratio, the Sterling ratio and the Burke ratio. These measures can be considered as a modification of the Sharpe ratio in the sense that the numerator is always the excess of mean returns over the risk-free rate while the standard deviation of returns in the denominator is replaced by some function of the drawdown Read more...
