Maximum Drawdown, Directional Trading and Market Crashes

Jan Vecer (Columbia University)

Maximum drawdown (MDD) measures the worst loss of the investor
who follows a simple trading strategy of buying and subsequently selling
a given asset within a certain time framework. MDD is becoming a
popular performance measure since it can capture the size of the market
drops. One can view the maximum drawdown as a contingent claim, and
price and hedge it accordingly as a derivative contract. Similar contracts
can be written on the maximum drawup (MDU). We show that buying
a contract on MDD or MDU is equivalent to adopting a momentum trading
strategy, while selling it corresponds to contrarian trading. Momentum
and contrarian traders represent a larger group of directional traders.
We also discuss how pricing and hedging MDD contract can be used to
measure the severity of the market crashes, and how MDD influences
volatility evolution during the periods of market shocks.