Everyone who trades forex will experience a downturn at some point in their careers because they are an inevitable part of the market. Even if the main trading strategy is profitable, drawdowns without effective risk management can completely devastate a trading account.
As a result, one of the most crucial performance measures to consider is drawdown.
In this post, I examine in detail the causes of drawdowns and the steps you can take to minimise them and increase your chances of trading success.
What is a Forex Drawdown?
Some of the deals I make will be profitable, while others will be losses. My account worth rises after each successful trade. My account worth drops after a bad trade. After a loss or string of losses, the account value declines, which is known as a drawdown.
I'm technically in a state of drawdown if my account worth ever falls below its previous historical peak value.
Because failed transactions will be mixed in with winning trades, minor drawdowns will occur frequently. Minor losses are a common occurrence in trading.
Drawdowns, however, can become big events if I experience a larger number of losses than usual, which is when I need to pay attention and modify my strategy.
Drawdowns are not account withdrawals:
When I transfer money from my trading account to my bank account, that is known as an account withdrawal. A drawdown is not the same thing. The term "drawdown" is only used by traders to refer to a decline in account value brought on by trading losses.
Why are Drawdowns Important in Forex Trading?
There are three major reasons why understanding drawdown in Forex can help you become a better trader:
- You can estimate when the next drawdown should conclude by being aware of your previous ones. For instance, if I know that my drawdowns often last two weeks, I won't worry if I'm just one week into one. If I rely on trading to make a living, knowing this is also helpful because I would rather take money out when my account worth is high than when it is low.
- Avoid letting your trading account go belly up. When a drawdown gets out of control, I run the risk of "crash and burn" and losing all of my money since I no longer have enough money to trade. I want to know ahead of time if I'm in danger of blowing out my account so I can change how I trade to avoid it. An astute trader once said to me, "It is essential to live to fight another day."
- You need to be aware of the status of your transaction. Even if I am profitable, the size and frequency of drawdowns tell me a lot about the health of my trading. My trading is not as good as it formerly was if my drawdowns increase in frequency or size. This can be a result of altered market circumstances. But it's also possible that it's because my abilities have diminished; whatever the case, I want to look into it. For instance, am I still trading inside my guidelines? Or am I making impulsive deals that are not consistent with my plan?
Types of Drawdowns
There are two main types of drawdowns:
- Absolute drawdown
- Maximal & relative drawdown
Absolute Drawdown
Absolute drawdown quantifies the amount by which the value of an account has fallen below the initial deposit.
It is 'absolute' because it always measures the drawdown using the initial investment as a constant or absolute value. This assessment is especially helpful when a trader is just getting started because most new traders want to make sure they shield a portion of their initial deposit from potential losses.
Absolute drawdown is typically expressed as a percentage (as opposed to a monetary value).
Maximal & Relative Drawdown
The value of the account has decreased by the most since its peak. The relative drawdown is typically the maximum drawdown expressed as a percentage, and the maximum drawdown is typically expressed as a dollar amount.
It should be noted that drawdowns do not require consecutive losses. There might be some gains thrown in with the losses, causing a general decline. For instance, I might suffer from 2 defeats, 1 win, and 2 more losses. A net downside could result from those 5 trades taken together.
How To Measure and Calculate Drawdowns
Methods for Determining Absolute Drawdown
I start by subtracting the initial deposit from the lowest value the account has ever attained. I next determine the proportion of the initial deposit that represents the difference between the two numbers.
Absolute drawdown is calculated as follows:
Initial Deposit = (Initial Deposit - Lowest Account Value).
Multiply the outcome by 100 to obtain a percentage.
Let's examine an illustration:
$10,000 as a down payment
My account's lowest balance is $7,500.
The initial deposit and the account's lowest historical value are separated by $2,500.
It is: expressed as a percentage of the initial deposit:
($2,500 / $10,000) x 100 = 25%.
Can I adjust my total drawdown?
Yes. My absolute drawdown may alter if the value of my account falls below the most recent record low.
How to Determine the Maximum Drawdown
Note that depending on the platform, the definitions of maximal and relative drawdown can vary, therefore my interpretation may not match others'.
The maximal drawdown, as the name implies, causes your trading account to drop the most money from a high point. This is also referred to by certain traders as the "peak to valley drop."
Let's imagine I increased the balance in my account from $10,000 to $20,000. After a losing streak where my account value dropped below $12,000, I eventually recovered.
My maximum drawdown is $8,000 in that situation.
Relative Drawdown Calculation Procedure
The maximum drawdown expressed as a percentage of the account's greatest value is known as the "relative drawdown."
According to the aforementioned example, if the account's maximum value was $20,000 before falling to $12,000, the relative drawdown would be 40% as a result of the account's 40% decline from $20,000 to $12,000.
The formula is as follows:
($20,000 - $12,000) / $20,000 = 0.4 or 40%.
Comparing closed trades and open equity to calculate drawdowns
Let's say I open a new trade after reaching a new high in my account balance. The deal moves 70 pip in my favour but then slightly declines. I close the position at a profit of 50 pip. Let's examine how I may determine drawdown using either the open equity or the closed balance using this example:
- The +70 pip new high point in my account value would be used in the open equity computation to determine future drawdowns.
- The +50 pip number would represent the new high point in my account value for the purposes of computing future drawdowns in the closed balance computation.
Periodic Drawdowns
Some traders prefer to divide their measurements into distinct time frames. What was the biggest drawdown this quarter, for instance? In what ways does it differ from the prior quarter? This is a clever method of performance monitoring because it informs me whether my outcomes are becoming better or worse.
The Importance of Measuring Drawdowns
A downturn streak is when a trader starts to lose too much money to the point where recovery is either impossible or very challenging. Drawdowns always begin slowly, but before you realise it, your account balance can be at an all-time low.
I might not notice the damage approaching if I'm not monitoring my drawdowns, and I might not know whether it's a brief blip or something more catastrophic. The worst aspect is that I might only detect a serious drawdown when it is already too late to undo the harm. Before altering their trades, I've observed traders whose account balances are down 70% to 80%. By that time, they require a gain of between 300% and 400% to equal their initial amount.
You can take proactive action to stop catastrophic damage from happening by measuring drawdowns. You can behave more strategically rather than emotionally by measuring drawdowns, which can help you avoid issues.
Steps to Control Drawdowns in Forex Trading
Risk must be managed in order to control drawdowns. Here is a straightforward five-step procedure that anyone can use.
- Employ a stop loss. Use a stop loss at all times, and never increase it once the transaction has been opened. Because they set a limit on each trade's risk, stop losses are the cornerstone of risk management.
- Aim for favourable reward to risk ratios. I won't take a transaction if the potential profit is less than the stop loss amount. Every transaction I make has a minimum reward to risk ratio of 1.5:1, which means I expect to make at least 1.5 times as much as I am willing to risk. A positive ratio indicates that I do not depend on a high win rate to generate income. Kristjan Kullamägi, a self-funded independent trader from Sweden, is a great real-world example. In 2020, he transformed $4 million into $32 million while only having a 30% win rate. He had exceptionally high profits relative to his risk in order to attain those returns.
- Set a maximum percentage risk for each trade you make. For instance, if the maximum risk for each trade is 2%, the stop-loss amount in dollars cannot be greater than 2% of the total value of the account. If I have a $10,000 balance in my account, a trade that is stopped out cannot cost me more than $200. If my stop loss size and Forex pairs are different for each transaction, I must figure out the position size for each trade. For instance, A GBP/USD trade with a 100-pip stop-loss and a EUR/USD trade with a 50-pip stop-loss will have a different position size. Additionally, it means that when the cash amount of my stop losses declines together with the value of my account, thus enhancing the protection of my account.
- Have a maximum withdrawal before further lowering risk. After a losing streak, the temptation is to up the risk because I want to recover my losses more quickly, but it is emotional trading. I am not in tune with the markets if I am going through a drawdown. Before increasing my risk level, I should first become in sync at a lesser risk level. For instance, if my account is down 10%, I will reduce my risk to 1% and wait until my account has recovered its prior equity high before increasing it back to its usual 2% level.
- Set a maximum drawdown before making a cash transaction. I might eventually reach a point where I am unable to stop draining my account. I want to halt trading and reevaluate before my account is completely decimated. For instance, if my account is 30% below where it was at its height, I will halt trading and review my strategy and execution.