Minimize Crypto Losses: How to Use Maximum Drawdown for Smarter Investing

 

Crypto is no longer foreign to every investor or the public, which is a digital asset today. Among the famous crypto tokens are bitcoin, ethereum and solana which are widely used in the blockchain ecosystem. However, its very volatile nature causes many investors to be cautious in avoiding the risk of significant losses, especially in a bear market. Therefore, maximum drawdown is used to measure the rate of loss in the value of a portfolio or asset for a certain period. This article will explain further how maximum drawdown can help investors in a bear market.

Understanding Maximum Drawdown

Maximum drawdown (MDD) is a critical risk metric used by investors to assess the largest peak-to-trough decline in the value of a portfolio or asset over a specified period. This measure is particularly significant during bear markets, when asset prices can experience sharp and prolonged declines. However, it is important to note that it only measures the largest losses without taking into account the frequency of the largest losses as MDD does not indicate how long it takes investors to recover from those losses.

Maximum drawdown is used to assess the relative riskiness of one strategy in screening stocks or crypto compared to another because it focuses on capital preservation which is of interest to every investor. For example, two screening strategies can have the same outperformance, tracking error and volatility but their maximum drawdowns compared to the benchmark may be very different.

Definition and Calculation

Maximum drawdown is defined as the greatest percentage drop from a portfolio's highest value (peak) to its lowest value (trough) before a new peak is achieved. The formula for calculating MDD is:

Max Drawdown % (MDD) =

This result is typically expressed as a negative percentage, reflecting the loss experienced during the period in question.

Importance in Bear Markets

Bear markets are characterized by sustained declines in asset prices, often triggered by economic downturns, financial crises, or shifts in investor sentiment. During these periods, maximum drawdown becomes a vital indicator for several reasons:

• Downside Risk Assessment: MDD quantifies the worst-case scenario for losses, helping investors understand the potential depth of a portfolio's decline during market stress.
• Strategy Evaluation: Comparing the MDD of different investment strategies or funds reveals which are more resilient in turbulent markets. Two portfolios with similar average returns and volatility can have vastly different drawdowns, influencing investor preference for risk management.
• Capital Preservation: Investors, particularly those with lower risk tolerance or near-term liquidity needs, prioritize strategies with lower MDDs to safeguard capital during downturns.

Example of Maximum Drawdown

An example of maximum drawdown calculation for bitcoin, ethereum and solana tokens in a bear market. Bear markets in crypto are often marked by a market price drop of more than 50% from its peak, which is caused by extremely negative market sentiment.

These examples underscore the severity of losses that can occur and highlight the importance of understanding MDD when constructing and managing portfolios in anticipation of bear markets.

Example of calculating maximum bitcoin drawdown:

Source: CoinMarketCap, Bitcoin ATH price

Source: CoinMarketCap, Bitcoin bottom price

Bitcoin (MDD) =  

This Maximum Drawdown is very important to investors because it will show the maximum potential loss that investors may experience if they buy at the peak and do not exit the market. In addition, maximum drawdown helps in comparing the risks between stablecoins and altcoins. Therefore, Maximum drawdown is very suitable for measuring the risk of investment strategies or portfolio performance.

In crypto, good Stablecoins like USDC or USDT usually have MDD ≈ 0-1%. Meanwhile, Altcoins or meme coins can reach MDD > 90%. So MDD helps make smarter and risk-aware decisions

Interpreting Maximum Drawdown

While MDD provides valuable insight into downside risk, it has limitations:

• No Recovery Information: MDD does not indicate how long it took to recover from the loss or whether the investment ever returned to its previous peak.
• Frequency of Losses: The metric focuses solely on the largest loss and ignores the frequency or pattern of smaller drawdowns.
• Context Matters: A high MDD in a volatile sector (e.g., technology) may be less concerning if offset by higher long-term returns, whereas a similar drawdown in a conservative portfolio may signal excessive risk.

Practical Application

Investors use maximum drawdown to:

• Set risk limits for portfolios.
• Compare fund managers and strategies, especially those claiming to be defensive or low-volatility.
• Adjust asset allocation to align with personal risk tolerance and investment horizons.

Conclusion

Maximum Drawdown is not a very powerful tool in planning an investment strategy but an important metric in assessing risk especially in a bear market. However, the time it takes for a market to recover cannot be measured by maximum drawdown. Therefore, investors should be wise in creating a strong strategy in the face of a bear market based on the history of the largest losses of an investment. As a strategy, investors can cut losses after the price reaches significant support to avoid suffering excessive losses.