What is maximum drawdown?

First, what is maximum drawdown? It is defined as the largest drop of a given asset within a certain time period.

Why calculate it? I've never made it a point to calculate maximum drawdown but I'm going to now. This is my attempt to start looking at more "advanced" money management concepts so I've decided to start with one of the easiest. The reason for calculating maximum drawdown is to measure the riskiness of your trading strategies. It will also give you an idea of how much money you could lose at some indeterminate point in time.

How do I calculate it? During the history of your trading strategy, I'm sure you'll be keeping track of your change in equity from one day to another, one week to another, one month to another, or whatever time period you choose. In the course of your trading, you will calculate drawdown which "represents the total percentage loss experienced by
a strategy before it starts winning again … and drives the
investment balance back up." (Source: http://www.confidentstrategies.com/maximum-drawdown.htm)

(Valley VAMI - Peak VAMI) / Peak VAMI

The Valley VAMI is the red arrow or approximately $1,100.

The Peak VAMI is the green arrow or approximately $1,425.

Therefore the drawdown is ($1100 - $1425)/$1425 or -22.8%.

Let's do 1 more example from the picture above. First let's find the Peak prior to the green arrow.

The Peak VAMI is approximately $1,250.

The Valley before the green arrow is at approximately $1,150.

Therefore the drawdown is ($1150-$1250)/$1250 or -8%.

So to find the maximum drawdown, select the drawdown that was greatest, in our example, -22.8%.

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