Drawdown in Forex is a fundamental metric that traders use to gage the amount of lost capital incurred from losing trades.
Knowledgeable traders use this information in order to calculate how likely their trading systems are to survive over the short and long run. Therefore a comprehensive understanding of drawdowns is a key component to knowing how viable your trading setup is and can be.
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Drawdown is a measurement of portfolio performance and how much it can absorb a loss before the loss starts to cut into profits.
A drawdown is related to a single position where you enter the position and the price may go against you and put you in a relative loss before going up once again.
It is also used to measure the health of an entire portfolio where you take the winners and the losers together to determine what was the highest sequence of accumulating losses in the portfolio.
The absolute drawdown is the numerical difference between the first deposit and the slightest point under the deposit level for the duration of the test. Simply put, this number tells you how big your loss can be while trading in relation to the first deposit you made.
This metric is usually used by Investors that are not actually measuring performance, but rather those that are only concerned with bringing returns.
The second type of drawdown in forex is relevant for traders who are always considering his or her performance efficiency. The relative drawdown is an indicator of how much these traders can risk as opposed to the initial investment amount. This is because the relative drawdown is the maximum drop of Equity in percentage, not an absolute amount.
There are two ways to measures relative drawdown:
1.Balance to equity:
The difference from the highest account Realized Balance to the following lowest Equity (unrealized Value).
Example: if you begin with a $10K evaluation account, the max. drawdown is $400 which means, the lowest Equity value is $9600.
if you earn $200 after a while, the account balance will be $10,200. Now, the lowest Equity value becomes $9800. (The drawdown functions like a trailing stop loss).
2.Equity to Equity:
This way of measuring is more strict from the other one, it measured the difference from the highest account unrealized Value to the following lowest unrealized Value (Equity ).
Example: if you begin with a $10K evaluation account, the max. drawdown is $400 which means, the lowest Equity value is $9600.
if you have a floating position with a $200 profit after a while, the account equity will be $10,200. Now, the lowest Equity value becomes $9800. (The drawdown functions like a trailing stop loss from equity to equity).
Five ways to keep drawdown in forex under control:
here are two ways to react if you reach the maximum drawdown:
Often times, these sorts of mistakes occur when there is a fundamental flaw in the trading strategy. It’s not always the case but in the event that you exceed your maximum drawdown, the first place you should go is your trading strategy. There may be a mistake that you overlooked which led to the chain of events culminating in the max drawdown.
This step is not separate from checking your strategy but rather something to do in conjunction if you decide not to stop trading while experiencing maximum drawdown. Regroup, cut your position size, reduce risk, and go from there.
If you’re a trader, you’ll always need to measure yourself statistically, from a relative drawdown. From any given point, your strategy combined with your trading ability is capable of making that amount of possible loss. This will define how risky your strategy is. This is very important to measure and work on so you’re always aware of what your possible risk is.
Thanks to Drawdown, as a trader you develop discipline.
It is very easy to lose direction in trading and not be disciplined, because of drawdown you know you have a limit, you will be a more careful and disciplined when trading forex.
You should always be aware of your relative drawdown while you’re trading. For example, if you make 100% profit but then lose 100%, it doesn’t make sense to say that you had a 50% drawdown. It’s not being honest about how you risk your money.
As always, most of this boils down to being honest with yourself and understanding your risk and knowing how to manage it.
Drawdown may limit you to a smaller profit, but it creates discipline and a work plan.
We wrote a similar article idea about The Lower Hanging Fruit – Forex Money Management Strategy.
That explains the benefits, of earning little, but consistently without leverage.
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