Drawdown is the peak-to-trough decline in the value of a trading account, expressed as a percentage from the highest equity point to the lowest point before a new high is reached. It is the most widely used measure of downside risk and trading strategy performance.
Drawdown is calculated by measuring the decline from a portfolio's peak value to its lowest point before recovering. If your account reaches $12,000 and then drops to $9,600 before recovering, the drawdown is ($12,000 - $9,600) / $12,000 = 20%. Maximum drawdown (MDD) is the largest peak-to-trough decline observed over the entire history of a strategy. The recovery factor matters too: a 20% drawdown requires a 25% gain to recover, while a 50% drawdown requires a 100% gain.
A trader starts with $10,000 and grows the account to $15,000. A losing streak brings the account down to $11,250. The drawdown from peak is ($15,000 - $11,250) / $15,000 = 25%. The trader needs a 33.3% return from $11,250 to get back to $15,000. This asymmetry between losses and required recovery is why managing drawdown is critical.
Drawdown directly impacts a trader's ability to recover and their psychological state. Large drawdowns require disproportionately large gains to recover and can lead to emotional decision-making, revenge trading, and strategy abandonment. Prop firms typically set maximum drawdown limits (5-10%) as their primary risk control, making drawdown management essential for funded traders.