Forex Blog Articles

Drawdown in Forex – How Does It Make You a Better Trader

January 15, 2020 | 11:02 am | Forex Blog Articles
January 15, 2020 | 11:02 am
Forex Blog Articles
Drawdown in Forex and How It Makes You a Better Trader

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.

 

What is Drawdown in Forex Trading?

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 Two Types of Drawdown

 

Absolute Drawdown

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. 

Relative Drawdown

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).

Understanding the two types of drawdown in forex
Understanding the two types of drawdown in forex

 

How to Keep Drawdown in Forex Under Control

Five ways to keep drawdown in forex under control:

  1. low risk – In fact, let’s make this a rule. Keep your risk below 1% of your total account. If you lose, you need to lose small.
  2. take a break – If you find your account heading south with no end in sight, it’s extremely important that you do whatever you can to immediately begin to reduce risk. Pour over your trading strategy and plan and find any place where risk prevention can be tightened. 
  3. rethinking – If you can’t limit risk and the losses just won’t stop, walk away. You can always pull the plug and the damage will be less than if you tried to weather the storm and your account got completely obliterated. 
  4. Continuity and consistency –  there is a building improvement, risk settle, and decreases, and your account starts to head in a positive direction. 
  5. leverage – Adjust the leverage according to the max drawdown you allowed for in your trading plan. This one is pretty self-explanatory. We’ve outlined the pros and cons of leverage in forex trading and if you can properly use it and control it, it can help you grow your account and succeed as a trader. 

 

Drawdown in Forex How Does It Make You a Better Trader

 

 

 

What to do if you Exceed the Maximum Drawdown?

here are two ways to react if you reach the maximum drawdown:

Stop trading and recheck your strategy

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. 

If you do continue, cut your position size

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. 

 

How Drawdown in Forex Helps You Manage Your Risk

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.

Drawdown in Forex The Bottom Line

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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