How Is Maximum Drawdown Different from Relative Drawdown?

In the world of trading and investing, risk management is crucial to long-term success. Whether you’re dealing with forex, stocks, crypto, commodities, or any other asset, understanding drawdowns can make the difference between staying in the game and losing it all. If youre diving into proprietary trading or even just honing your skills as an independent trader, youve probably come across two terms that can sound similar but mean different things: maximum drawdown and relative drawdown. So, what exactly sets them apart? Lets break it down.

Understanding Drawdown: A Crucial Risk Measure

Before we jump into the specifics of maximum and relative drawdowns, let’s quickly define "drawdown." A drawdown refers to the decline in the value of an investment from its peak to its trough. Its a critical risk metric, especially for traders who manage their own capital or trade using leverage.

Drawdowns can happen for all sorts of reasons — market volatility, sudden news events, poor trade decisions, or simply bad luck. But regardless of the cause, understanding drawdowns helps traders assess how much loss they can tolerate in any given scenario.

What Is Maximum Drawdown?

Maximum drawdown (MDD) is a straightforward but powerful concept. It refers to the greatest peak-to-trough loss during a specific period in an investment or trading account. Simply put, its the worst drawdown your account has experienced historically.

For example, let’s say you have a trading account that grows to $100,000. At its peak, it drops to $80,000 before bouncing back up. In this case, the maximum drawdown would be $20,000, which represents a 20% loss.

Key Characteristics of Maximum Drawdown:

• Historical Perspective: It measures the largest loss from any peak to trough during the entire history of a trader’s account or a specific trading strategy.
• Emotional Impact: Since MDD shows the largest loss, it gives traders a clear understanding of the worst-case scenario. A trader who has experienced a maximum drawdown of 30% might feel less anxious about a 10% loss.
• Indicator of Risk: MDD is often used to evaluate the risk profile of a trader or a fund. It’s especially valuable when comparing different strategies to see which one can withstand the harshest market conditions.

In prop trading (proprietary trading), where firms use their own capital to trade on behalf of clients or themselves, maximum drawdown can be an important metric for setting risk management strategies. Firms typically use MDD to determine whether a trading strategy is viable or too risky, potentially affecting how much leverage or margin is offered.

What Is Relative Drawdown?

Relative drawdown is a bit different from maximum drawdown. While MDD focuses on the absolute amount lost from the peak, relative drawdown measures the loss as a percentage of the peak value.

For instance, let’s say a trader’s account grows from $50,000 to $100,000, and then the account drops to $75,000 before recovering. The maximum drawdown would be $25,000, but the relative drawdown is calculated as:

[ \text{Relative Drawdown} = \frac{\text{Peak Value} - \text{Lowest Value}}{\text{Peak Value}} \times 100 = \frac{100,000 - 75,000}{100,000} \times 100 = 25\% ]

Key Characteristics of Relative Drawdown:

• Percentage-Based: Unlike MDD, which shows the absolute dollar loss, relative drawdown shows the loss in relation to the highest peak. This makes it useful when comparing performance across different strategies or portfolios.
• Helps Gauge Proportional Risk: Relative drawdown gives a clearer view of how severe a loss is relative to a traders capital. Its a helpful metric when determining whether a trading strategy is sustainable over time.
• Broader Application: Relative drawdown is often favored when comparing strategies across different asset classes, as it allows for easier comparison despite varying account sizes or initial investments.

Comparing Maximum and Relative Drawdown: Which Is More Useful?

At first glance, maximum drawdown and relative drawdown might seem like two sides of the same coin. But they serve different purposes, and understanding both is essential for successful risk management.

• Risk Assessment: If youre evaluating the absolute worst-case scenario, MDD is the go-to metric. However, if you want to understand the proportionality of the risk, relative drawdown is more useful.
• Strategy Evaluation: When testing a new trading strategy, maximum drawdown can help you evaluate its worst performance. On the other hand, relative drawdown can help you understand how the strategy behaves relative to your overall account size or other strategies.
• Capital Allocation: For those managing multiple strategies or assets, relative drawdown offers a better way to gauge how much capital should be allocated. It tells you not just how much you can lose, but how much you can lose relative to your peak value.

The Role of Drawdowns in Prop Trading and DeFi

Now, let’s zoom out and think about the bigger picture, especially in the world of proprietary trading and decentralized finance (DeFi). As the market evolves, traders are looking for ways to mitigate the impact of drawdowns.

In prop trading, for instance, firms often have strict risk management rules. A strategy that consistently experiences a high maximum drawdown may be considered too risky, leading to reduced leverage or even removal from a firms portfolio. On the other hand, strategies that show relatively smaller drawdowns are often favored.

With the rise of DeFi and decentralized exchanges, the rules of traditional trading are being challenged. While DeFi offers the allure of transparency and lower fees, it also introduces new risks—market manipulation, lack of liquidity, and extreme volatility, especially in crypto assets. In this environment, understanding drawdowns is even more important to gauge the potential risks involved