What it is
Maximum drawdown is the largest peak-to-trough decline in an equity curve, expressed as a percentage of the peak. It is the most direct answer to the question of how bad things got, and for most people it is the constraint that decides whether a strategy can actually be traded rather than merely admired.
How it works
It is computed by tracking the running maximum of equity and, at each point, the ratio of current equity to that maximum minus one; the minimum of that series is the maximum drawdown. Two companion measures matter as much: the length of the drawdown, meaning how long the account stayed below the old peak, and the time taken to recover. The Calmar ratio divides annualised return by maximum drawdown to compare strategies on exactly this basis.
How traders use it
The recovery arithmetic is asymmetric and worth internalising. A 20 percent drawdown needs a 25 percent gain to get back to even, a 50 percent drawdown needs 100 percent, and an 80 percent drawdown needs 400 percent. This is why controlling the left tail matters more than maximising the average return, and why leverage that improves the mean can destroy the compounded result.
Where it breaks down
As a statistic it is fragile. It is a single extreme observation, so it depends heavily on the sample window and changes when the start date shifts, and the future worst case is on average worse than the historical one simply because more time means more chances for a bad run. Drawdowns computed on daily closes also understate what was experienced intraday. Treat the backtested figure as a floor for expectations rather than a ceiling.
Educational reference. This entry describes how a concept is defined and used. It is not investment advice, not a recommendation, and not a signal. Any rule you build from it should be tested with realistic costs before it is traded, and no historical result guarantees a future one.