Drawdown Mathematics: Losses, Recovery and Risk

Drawdown is the decline from a previous balance or equity peak. If the peak is (P) and the current value is (V): drawdown = (P − V) ÷ P The recovery return is measured from the reduced value: recovery required = drawdown ÷ (1 − drawdown)

Recovery table

The relationship is nonlinear. A 50% loss and a 50% gain do not cancel because the gain is earned on a smaller capital base.

Drawdown definitions

Different measurements answer different questions:

• Closed-balance drawdown: ignores unrealized positions.
• Equity drawdown: includes open profit and loss.
• End-of-day drawdown: samples once per day and may miss intraday lows.
• Absolute drawdown: compares current value with starting capital.
• Trailing drawdown: moves the failure threshold with a high-water mark.

State the definition before comparing results.

What creates drawdown

Drawdown depends on more than win rate:

• average and tail loss;
• sequence and dependence of outcomes;
• position-sizing policy;
• correlated simultaneous positions;
• gaps, slippage, and fees;
• changes in strategy edge;
• execution and operational failures.

Higher position risk usually increases drawdown, but the path also depends on the payoff distribution and exposure timing.

Drawdown as a path constraint

A strategy can finish a test profitably and still cross a failure boundary along the way. This distinction is central to prop trading, where a daily or maximum-loss breach ends the account regardless of the later hypothetical recovery. Simulations should therefore calculate intraday or trade-by-trade equity using the firm’s actual rules, not only terminal return.