Daily Drawdown and Max Drawdown: How to Calculate it

The Daily Drawdown and Max Drawdown (MDD) are two important indicators that assist investors in estimating possible losses. Knowing how to calculate daily and max drawdown is of utmost importance. In the realm of trading and investing, it is critical to understand risk. These indicators aid in the development of future initiatives in addition to offering insights into historical performance. The definitions, meanings, and computation techniques of daily drawdown and max drawdown will be covered in detail in this article.

What Is Drawdown

When an investment’s value drops from its peak to its lowest point before reaching a new top, this is known as a drawdown. It is a crucial measure of risk that helps investors understand the potential volatility of their investments. The following formula can be used to express the drawdown as a percentage:

• Percentage Drawdown = (Highest Peak Value − Lowest Trough Value / Highest Peak Value) × 100

For instance, the drawdown might be as follows if an investment peaked at $200 and then fell to $150:

• Drawdown = (200−150 / 200) × 100 = 25%

Daily Drawdown 

The greatest drop in an investment’s value in a single trading day is referred to as the “daily drawdown.” For day traders who must properly manage short-term risks, this statistic is especially helpful.

Daily Drawdown Calculation

Usually, a percentage of the starting equity or balance for the day is used to compute the daily drawdown. One way to express the formula is:

• Daily Loss Limit = Initial Balance × Percentage of Daily Loss Limit

For example, the computation might be as follows if a trader is permitted a daily drawdown of 5% and starts with an initial balance of $100,000: 

• Daily Loss Limit = 100,000 × 0.05 = 5,000

This implies that the trader cannot lose more than $5,000 in a single trading day. They would have exceeded their daily drawdown cap if their balance dropped below $95,000.

Maximum Drawdown (MDD)

The largest peak-to-trough drop in an investment’s value over a given time period is measured by the Maximum Drawdown (MDD). Since it shows the worst-case scenario for possible losses, this indicator is crucial for long-term investors.

The Importance of the Maximum Drawdown

Investors can evaluate the risk of their investing strategy with the aid of an understanding of MDD. Significant volatility and risk are indicated by a high MDD, whereas more stable performance is suggested by a low MDD. MDD is frequently used by investors to compare various investment options or portfolios.

Maximum Drawdown Calculation

To determine MDD, take the following actions:

• Determine the portfolio’s maximum peak value. 
• After that peak, find the lowest trough value.
• Apply the following formula:

Maximum Drawdown MDD = (Trough Value − Peak Value / Peak Value) × 100

Take, for instance, an investment portfolio that peaks at $100 million and then falls to $50 million during a market decline. This is how the MDD would be determined:

• MDD = (50 million − 100 million / 100 million) × 100 = −50%

This suggests that the portfolio’s highest drop from its peak was 50%.

Disparities Between the Daily Drawdown and the Maximum Drawdown

Although both maximum drawdown and daily drawdown are essential for risk assessment, they have distinct functions: 

1. Time Frame

• Daily Drawdown: Intraday
• Maximum Drawdown: Over a Specific Period

2. Focus

• Daily Drawdown: Short-term Fluctuation
• Maximum Drawdown: Long-term Assessment Of Risk

3. Calculation Basis

• Daily Drawdown: Based On Daily Balance
• Maximum Drawdown: Based on Historical Peak and Trough Values

4. Use Case

• Daily Drawdown: Risk Management for Day Trading
• Maximum Drawdown: Portfolio Performance Evaluation

Use of Drawdowns in Practice

Investors can make wise judgments regarding their portfolios by being aware of both maximum drawdown and daily drawdowns. They can be used practically in the following ways:

• Risk Management: Traders can avoid suffering undue losses in erratic markets by establishing daily drawdown limits.
• Performance Evaluation: By using MDD, investors can assess historical performance and modify their plans as necessary.
• Portfolio Comparison: Investors can select assets that are in line with their risk tolerance by comparing MDD across several portfolios.

In conclusion

To sum up, both maximum drawdown and daily drawdown are crucial instruments for controlling investment risk. They assist investors in making well-informed choices regarding their trading tactics and offer insightful information about possible losses. Traders and investors can more successfully manage market swings and safeguard their wealth by knowing how to compute these measures and their ramifications. 

Understanding these ideas will enable investors to improve their tactics and attain greater financial results as markets continue to change. Understanding these drawdown indicators is essential for effective investing in the ever-changing financial landscape of today, regardless of whether you’re a long-term investor evaluating portfolio performance or a day trader trying to control short-term risks.

Frequently Asked Questions

1. What Does A 5% Daily Drawdown Mean?

• Your trading account cannot lose more than 5% of its entire value in a single day if you have a 5% daily drawdown. For example, a 5% daily drawdown limit would permit losses of up to $2,500 if your account balance was $50,000. You would go above this restriction if your balance dropped below $47,500 during the day.

2. Does Drawdown Reset Every Day?

• Yes, at the beginning of every new trading day, the daily drawdown usually resets. This implies that the drawdown computation is restarted based on the performance of the day when a new trading session starts.

3. What Is Maximum Drawdown (MDD

• Maximum drawdown (MDD) calculates the biggest peak-to-trough drop in an investment or portfolio’s value during a given time frame. It helps investors comprehend downside risk and offers insights into possible losses.

4. Do Different Daily Drawdown Types Exist?

Indeed, daily drawdowns come in two main varieties:

• Intraday Daily Drawdown: Based on current price movements, this metric calculates the peak-to-trough fall over the course of a single trading day.
• conclusion-of-Day Daily Drawdown: Compares closing values at the conclusion of the trading day to determine the peak-to-trough fall.

5. What Takes Place If You Go Over Your Daily Drawdown Cap?

• Depending on the regulations of your trading platform or prop firm, going over your daily drawdown limit may have dire repercussions. Account termination or limitations on future trading activity for that day are the usual outcomes.