Drawdown measures how far your account has fallen from its peak. If your account grew to $50,000 and then dropped to $40,000, you're in a 20% drawdown — regardless of where you started. It measures loss from the most recent high, not from your starting balance.
Drawdown is the most honest measure of trading performance. A strategy with a 50% annual return but a 40% max drawdown is objectively worse than one returning 25% with a 10% max drawdown — the risk-adjusted return is inferior and the psychological difficulty of holding through a 40% decline would cause most traders to abandon the strategy at the worst moment.
The Formula
Max Drawdown = (Peak value − Trough value) ÷ Peak value × 100
If the account peaked at $30,000 and bottomed at $21,000 before recovering: ($30,000 − $21,000) ÷ $30,000 = 30% max drawdown.
Absolute vs Relative Drawdown
Absolute drawdown: How far below your starting balance the account fell at its worst point. Relevant for understanding worst-case outcomes from inception.
Relative (max) drawdown: The largest peak-to-trough decline over any period, expressed as a percentage. This is the standard metric used by fund managers, prop firms, and risk systems.
The Recovery Math
Recovering from a drawdown takes proportionally more than what was lost — a fact that changes how you should think about risk:
| Drawdown | Gain needed to recover |
|---|---|
| 10% | 11.1% |
| 20% | 25.0% |
| 30% | 42.9% |
| 40% | 66.7% |
| 50% | 100.0% |
| 60% | 150.0% |
A 50% drawdown requires doubling the account just to get back to flat. This is why professionals treat drawdown limits as hard rules — a 25% drawdown is recoverable. A 60% drawdown often isn't, psychologically or financially.
How to Manage Drawdown
The only reliable way to control drawdown is position sizing. Every percentage point of per-trade risk you add increases your potential drawdown roughly proportionally. Risking 2% per trade instead of 1% doesn't just double expected returns — it doubles expected drawdowns.
Most professional traders target a max drawdown of 10–20%. If your drawdown consistently exceeds this, reduce position size first before anything else. A smaller account growing at 15% per year with controlled drawdowns will outperform an aggressive account that keeps hitting 30–40% drawdowns and spending months in recovery.
Prop trading firms commonly use a 5–10% daily drawdown limit and a 10–20% overall drawdown limit as a kill switch — once breached, all trading stops. These limits exist because they've watched traders blow accounts trying to recover quickly through bigger bets, which compounds the problem.