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• Understanding Max Drawdown (%)

Understanding Max Drawdown (%)

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Let’s unpack this clearly — both what Max Drawdown % means, and why it often signals that “the backtesting game is over.”

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💡 What is Max Drawdown (%)?

Max Drawdown (MDD) is a key risk metric that measures the largest peak-to-trough decline in your portfolio or strategy equity curve during a given period, expressed as a percentage.

Formally:

$$\text{Max Drawdown (\%)} = \frac{\text{Peak Value - Trough Value}}{\text{Peak Value}} \times 100$$

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🔍 Example

Suppose your backtested strategy’s equity curve goes:

Then:

$$\text{MDD} = \frac{130,000 - 85,000}{130,000} = 34.6\%$$

This means at one point, your account dropped 34.6% from its high before recovering.

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⚠️ Why It Matters

• Drawdown = Pain. A big drawdown means real psychological and financial stress.
  Most traders (or investors) quit or get liquidated long before recovery.

• It defines risk tolerance. You can survive a 10% drawdown.
  You might survive 25%.
  You probably won’t survive 60%.

• It’s about time, not just loss. Recovery from large drawdowns takes exponentially longer.

  Drawdown	Gain Needed to Recover
  10%	+11.1%
  20%	+25%
  50%	+100%
  80%	+400%

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🎮 “The Backtesting Game is Over” — What That Means

When traders say “the backtesting game is over”, they mean that your backtest no longer matters because your strategy’s Max Drawdown is too large to be realistic or survivable in live conditions.

Reasons why:

1. Overfitting reality:
   Your backtest might look great until one period crushes it. A huge drawdown shows your strategy wasn’t robust — it just worked on past noise.

2. Unrealistic assumptions:
   Backtests often assume perfect execution, no slippage, infinite liquidity, and no emotions — which hide drawdown risk.

3. Capital destruction:
   Once you hit catastrophic drawdowns (>30–40%), compounding breaks.
   You’re no longer in a position to recover — the “game” (simulation or real capital) is effectively over.

4. Psychological and funding limits:
   Even if a backtest recovers, you or your investors probably wouldn’t sit through a 50%+ drawdown.
   So the system, in practice, is dead.

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🧭 Takeaway

Max Drawdown % isn’t just a number — it’s a survival threshold.

When it gets too large, it tells you:

“This strategy may have been profitable in a spreadsheet, but it wouldn’t survive the real market.”

That’s why when you see an equity curve collapse and Max Drawdown spikes,
👉 the backtesting game is over.

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