# Maximum drawdown

Maximum drawdown is the largest percentage decline from a prior peak to a subsequent low in an investment’s value over a specified period.

## What it means

Maximum drawdown describes the worst peak-to-trough fall observed in a value series over a chosen period. The series could track one stock or an entire portfolio. Each low must occur **after** the peak used to measure it; subtracting the lowest value from an earlier low or a later high would not measure a drawdown.

It is usually reported as a positive percentage loss. A 25% maximum drawdown means the value fell 25% from a preceding high at some point in the period. It does not mean the investment ended the period down 25%, nor does it describe how long a recovery took. The observation window matters: extending it can reveal a deeper decline.

## How it is calculated

At each observation, compare the current value with the highest value recorded up to that point. Then select the largest resulting decline:

`Peak_t = max(V_0, V_1, ..., V_t)`

`Drawdown_t = (Peak_t - V_t) / Peak_t`

`Maximum drawdown = max(Drawdown_t) for all observations t in the period`

- `V_t` is the stock or portfolio value at observation `t`, measured in currency units such as US$.
- `V_0` is the starting value. Include it when establishing the first peak.
- `Peak_t` is the highest value observed from the start through `t`, in the same currency units.
- `Drawdown_t` is the decline from that peak, expressed as a fraction; multiply by 100 for a percentage.

For a portfolio, specify whether the series includes dividends, fees, deposits and withdrawals. Cash flows can change account value without reflecting investment gains or losses, so a cash-flow-adjusted series is preferable when comparing investment performance. The formula also requires positive peak values; it is not directly meaningful for a series whose peak is zero or negative.

## Worked example

Suppose a hypothetical portfolio has the following values at five month-ends, with no deposits or withdrawals:

| Month-end | Value | Highest value so far | Drawdown |
|---|---:|---:|---:|
| 1 | US$10,000 | US$10,000 | 0% |
| 2 | US$12,000 | US$12,000 | 0% |
| 3 | US$9,000 | US$12,000 | 25% |
| 4 | US$11,000 | US$12,000 | 8.33% |
| 5 | US$8,000 | US$12,000 | 33.33% |

1. By month 2, the highest observed value is US$12,000.
2. At month 3, the decline is `(US$12,000 - US$9,000) / US$12,000 = 25%`.
3. At month 5, the decline is `(US$12,000 - US$8,000) / US$12,000 = 33.33%`.
4. The **maximum drawdown is 33.33%** across these observations. The partial rebound in month 4 did not establish a new peak.

Because these are month-end figures, an intramonth low could have produced a larger maximum drawdown on daily data.

## Why it matters before you trade

Maximum drawdown makes a past loss concrete in a way that an average return or volatility figure may not. A decline of 33.33% requires a subsequent gain of approximately 50% from the lower value to regain the prior peak. That arithmetic can help put a proposed position size or concentration level in context.

Before a trade, distinguish a historical maximum drawdown from a potential future loss. The historical figure depends on the chosen dates, observation frequency, valuation method and whether total returns are included. It cannot set a reliable limit on what might happen next. A single-stock history may also differ substantially from the drawdown of the broader portfolio that holds it.

## How PreTrAIde uses it

The product facts do not say that PreTrAIde calculates or reports maximum drawdown. Its pre-trade analysis instead assesses a proposed stock basket using measures including estimated daily volatility, one-day 95% value at risk, liquidity, market impact and portfolio concentration. These measures address different questions; none is interchangeable with the largest observed peak-to-trough decline over a historical period.

PreTrAIde returns GO, NO-GO or MODIFY verdicts as decision support, not recommendations. Its success probability is a model estimate, not a guarantee or a forecast of returns. A user considering historical drawdown would need to evaluate it separately from those pre-trade checks.

## Common mistakes

- **Using the final return instead:** A portfolio can finish above its starting value and still have experienced a substantial drawdown along the way.
- **Pairing dates incorrectly:** The trough must follow the peak, and every observation uses the highest value reached by then.
- **Mixing sampling frequencies:** Month-end data can miss losses visible in daily or intraday data.
- **Ignoring cash flows:** Deposits and withdrawals can distort drawdown calculated from an unadjusted account balance.
- **Treating history as a loss ceiling:** A past maximum is an observation, not a limit on future declines.

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Source: https://pretraide.com/glossary/maximum-drawdown