How to read drawdowns

A drawdown is the peak-to-trough decline of an equity curve, measured from the most recent high-water mark. Max drawdown is the largest such decline observed in a sample. Drawdown duration is how long the curve stayed underwater before reaching a new high.

Drawdown is the most honest part of a backtest because it tells the reader what living with the rule felt like, not just where it ended up.

Two backtests can both report a max drawdown of 15%. One reached it in three weeks and recovered in two months. The other took 14 months underwater. They are very different products for a learner to study, and the difference is invisible if you only read the magnitude.

Reading the drawdown series — the chart of underwater periods over time — is the single most informative thing a reader can do before forming a view.

Drawdowns cluster. A strategy can spend most of its sample with shallow underwater periods and then concentrate several deep drawdowns around an event window. Indian options strategies often see clustering around RBI policy days, budget days, expiry weeks, and election results.

Clustering matters because position sizing is usually set on average behaviour. A rule that experiences three -8% drawdowns in a single month is much harder to size than a rule with one -8% drawdown a year, even if the max drawdown number is identical.

Recovery time is how long the equity curve takes to make a new high after a drawdown. A strategy with fast recovery times is psychologically easier and operationally more useful. A strategy with long recovery times will be abandoned by most independent learners well before the historical recovery completes.

Drawdowns scale linearly with position size. A historical max drawdown of 12% at a given size becomes a max drawdown of 24% at double the size. Before forming any view on a backtest, the reader should ask whether the drawdown would be tolerable at the position size they would actually study.