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).
Somewhat more formally, if is a stochastic process with , the drawdown at time , denoted , is defined as:
The following pseudocode computes the Drawdown ("DD") and Max Drawdown ("MDD") of the variable "NAV", the Net Asset Value of an investment. Drawdown and Max Drawdown are calculated as percentages:
MDD = 0 peak = -99999 for i = 1 to N step 1 do # peak will be the maximum value seen so far (0 to i), only get updated when higher NAV is seen if (NAV[i] > peak) then peak = NAV[i] end if DD[i] = 100.0 × (peak - NAV[i]) / peak # Same idea as peak variable, MDD keeps track of the maximum drawdown so far. Only get updated when higher DD is seen. if (DD[i] > MDD) then MDD = DD[i] end if end for
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.
2. How long it lasts (the duration)
- The drawdown duration is the length of any peak to peak period, or the time between new equity highs.
- The max drawdown duration is the worst (the maximum/longest) amount of time an investment has seen between peaks (equity highs).
Many assume Max DD Duration is the length of time between new highs during which the Max DD (magnitude) occurred. But that isn’t always the case. The Max DD duration is the longest time between peaks, period. So it could be the time when the program also had its biggest peak to valley loss (and usually is, because the program needs a long time to recover from the largest loss), but it doesn’t have to be.
When is Brownian motion with drift, the expected behavior of the MDD as a function of time is known. If is represented as:
- implies that the MDD grows logarithmically with time
- implies that the MDD grows as the square root of time
- implies that the MDD grows linearly with time
Banking or other finance definitions
Where an amount of credit is offered, a drawdown against the line of credit results in a debt (which may have associated interest terms if the debt is not cleared according to an agreement.)
Where funds are made available, such as for a specific purpose, drawdowns occur if the funds – or a portion of the funds – are released when conditions are met.
Optimization of drawdown
A passing glance at the mathematical definition of drawdown suggests significant difficulty in using an optimization framework to minimize the quantity, subject to other constraints; this is due to the non-convex nature of the problem. However, there is a way to turn the drawdown minimization problem into a linear program.
The authors start by proposing an auxiliary function , where is a vector of portfolio returns, that is defined by:
- is the average drawdown
- is the maximum drawdown
- "What Is A Drawdown? – Fidelity". www.fidelity.com. Retrieved 2019-08-04.
- Magdon-Ismail, Malik; Atiya, Amir F.; Pratap, Amrit; Abu-Mostafa, Yaser S. (2004). "On the Maximum Drawdown of a Brownian Motion" (PDF). Journal of Applied Probability. 41 (1): 147–161. doi:10.1239/jap/1077134674.
- Chekhlov, Alexei; Uryasev, Stanislav; Zabarankin, Michael (2003). "Portfolio Optimization with Drawdown Constraints" (PDF).
- Chekhlov, Alexei; Uryasev, Stanislav; Zabarankin, Michael (2005). "Drawdown Measure in Portfolio Optimization" (PDF). International Journal of Theoretical and Applied Finance. 8 (1): 13–58. doi:10.1142/S0219024905002767.
- Burghardt, G., Duncan, R. and L. Liu, "Understanding Drawdowns", working paper, Carr Futures (September 4), 2003
- Eckholdt, H., "Risk Management: Using SAS to Model Portfolio Drawdown, Recovery and Value at Risk" (February), 2004. [What journal was this in?]
- Goldberg, L.R. and O. Mahmoud, "On a Convex Measure of Drawdown Risk", working paper, Center for Risk Management Research, UC Berkeley, 2014. (http://ssrn.com/abstract=2430918)
- Grossman, S. J. and Z. Zhou, "Optimal Investment Strategies for Controlling Drawdowns", Mathematical Finance 3, pp. 241–276, 1993.
- Hamelink, F. and M. Hoesli, "The Maximum Drawdown as a Risk Measure: The Role of Real Estate in the Optimal Portfolio Revisited", working paper (June 24), 2003.
- Hayes, B. T., "Maximum Drawdowns of Hedge Funds with Serial Correlation", Journal of Alternative Investments (vol 8, no 4) (Spring), pp. 26–38, 2006.
- Kim, Daehwan, "Relevance of Maximum Drawdown in the Investment Fund Selection Problem when Utility is Nonadditive", working paper (July), 2010.
- Magdon-Ismail, M. and A. Atiya, "Maximum Drawdown", Risk Magazine (October), 2004. (http://alumnus.caltech.edu/~amir/mdd-risk.pdf)
- Steiner, Andreas, "Ambiguity in Calculating and Interpreting Maximum Drawdown," working paper (December), 2010.
- Wilkins, K., C. Morales and L. Roman, "Maximum Drawdown Distributions with Volatility Persistence", working paper, 2005.