Introduction:
Stocks are a highly lucrative investment option. You can invest in shares of different companies to gain handsome returns in short spans. However, they are equally risky. The values of shares change almost every second during trading hours, and if you aren’t diligent enough, you can lose a lot of money.
Thus, you must conduct a technical analysis before investing your hard-earned money. You can use specific indicators to gain insights into the market psychology and forecast future price movements. In this article, we will talk about one such indicator – Maximum Drawdown.
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What is a drawdown?
Before learning about maximum drawdown, you must know what a drawdown is. It is the difference between a peak and a trough in the market value of an asset during a particular trading window. It is not the same as your actual loss, which you can calculate by subtracting an asset's selling price from the purchase price.
A drawdown evaluates the historical risk associated with an asset (stock in this case). Understanding drawdown meaning can help you manage market volatility, gauge through turbulent times, and know the maximum loss you can incur in your investment.
What is a maximum drawdown?
There can be different drawdown measurements during a trading window, including the Maximum Drawdown (MDD), the Relative Drawdown (RDD), and the Absolute Drawdown (ADD). The MDD measures the difference between the highest peak and lowest trough in an investment's value before achieving a new peak.
In other words, a maximum drawdown is the highest loss when the assets in a portfolio are measured from their highest peaks to their lowest troughs before forming new peaks. As an indicator, the MDD reflects the downside risk in an investment over a specified period. It is expressed as a percentage.
You can use an MDD indicator in your technical analysis chart on a standalone basis or with other indicators, such as the Calmar Ratio and the Return Over Maximum Drawdown.
The formula to calculate the maximum drawdown
The formula to calculate the maximum drawdown value is as follows:
MDD = [(Trough Value – Peak Value) / Peak Value] x 100
As this formula suggests, maximum drawdown measures only the extent of the highest loss in a portfolio. It does not consider the frequency of these peaks or troughs. Since MDD reflects only the maximum loss you can incur in your portfolio, it doesn’t indicate the period in which you can suffer or recover this loss.
Understanding MDD with an example
Suppose you invest Rs. 10 lakhs in particular assets. Over time, your investment value increased to Rs. 15 lakhs before plunging to Rs. 8 lakhs during a bearish phase. Then, the value of your investments rebounds to Rs. 12 lakhs before dropping to Rs. 7 lakhs again. But then, it suddenly shoots to Rs. 16 lakhs during a strongly bullish market.
So, what will be the maximum drawdown of your investment as per the formula mentioned above:
MDD = [(7,00,000 – 15,00,000) / 15,00,000] x 100, i.e., -53.33%
A few points to note here are:
- You will consider the highest peak value of Rs. 15 lakhs and not the other peak value of Rs. 12 lakhs as it isn't the highest
- The latest peak value of Rs. 16 lakhs is also not considered as we are supposed to use the first highest peak value before forming a new peak
- You will consider the lowest trough value of Rs. 7 lakhs. The first trough value of Rs. 8 lakhs isn’t the lowest trough value during the trading period
Maximum drawdown vs. relative drawdown vs. absolute drawdown
Maximum drawdown, relative drawdown (RDD), and absolute drawdown (ADD) are the three metrics you can use to analyze your investment portfolio. The table below describes the difference between them:
To conclude
MDD is a useful technical indicator for analyzing your portfolio performance. You can also use this indicator to decide on your asset allocation strategy for maximum returns. Ideally, an MDD of 25% or lower is optimal with anything above it indicating a high-risk investment.
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