One of the most important rules of Forex trading is to limit the amount of money you lose in trading (your “drawdown”) before your losses start eating into your gains. Successful foreign exchange (Forex) trading entails more than just making money on currency trades; it also requires limiting the adverse effects of transactions on your account balance, known as drawdowns.
Traders with more experience or a higher percentage of success than newer traders often have a better grasp of how to deal with drawdowns. Most seasoned investors place a premium on limiting their exposure to loss and keep a close eye on their trading positions and overall portfolio status. By experiencing drawdowns, traders can learn whether or not their trading techniques are sustainable over the long term and adjust their position size accordingly.
List of contents
What Is Drawdown in Forex
Drawdown is the proportion of consecutive lost trades in the foreign exchange market. It represents the amount deducted from your account following forex trading losses.
For instance, if the balance of your MT5 account is $15,000. However, after a few days of trading, the amount of your account is now $10000. After a few additional days, you are able to generate a profit and increase your account balance from $10k to $16k. Now your entire drawdown amount is $1,000, or 10% drawdown.
Types of Drawdown in Forex
In forex trading, there are three main drawdown strategies. A firm grasp of these words is essential before investing or trading to check a portfolio’s status.
- Relative Drawdown
- Absolute Drawdown
- Maximum Drawdown
Relative Drawdown (DD)
The relative drawdown measures the decline from the peak to the bottom of the equity market. Remember that We have used the term “equity,” which refers to an unrealized gain or loss. Instead of a fixed number, the relative drawdown is calculated based on the amount of equity.
To illustrate
Suppose you had a $10,000 trading account and decided to initiate two trades in the EURUSD currency pair. Your account equity was $9,500 after the first 60 minutes, but it increased to $10,500 after the second 60 minutes.
Let’s say $9,500 and $10,500 are the minimum and maximum amounts, respectively. When you compare the two numbers, you’re experiencing what is known as a relative drawdown.
Formula
Relative Drawdown = Maximum equity value – Minimum equity value
Relative DD in percentage = (Maximum equity value– Minimum equity value)/Maximum equity value×100
Absolute Drawdown
The key to Absolute Drawdown is the percentage of a portfolio’s value that has been lost, expressed as a percentage of the beginning balance.
To illustrate
let’s assume that after a few months of trading, you saw your $10,000 trading account grow to $15,000. However, something causes your $15k balance drops to only $10,000. Your balance has finally reached zero, at which point any further investment would be profitable. Since trading commenced at the opening balance and terminated at the breakeven point, the total Absolute Drawdown will be zero.
Formula
Absolute Drawdown formula = Initial Balance – maximum loss in the initial balance
Absolute DD in percentage = (Initial balance – maximum loss in initial balance)/(initial balance)×100
It’s a significant aid in analyzing the performance of a trading account.
Maximum Drawdown
Maximum drawdown refers to the gap between the account’s all-time high and all-time low balances.
To illustrate
A trading account may double in size from $10,000 to $30,000 in a matter of months. Considerable decreases in account amount from the opening balance occurred over this period, with the most significant reduction being $7,000. The current maximum withdrawal amount is $23,000.
Formula
Max Drawdown Formula = all-time balance high – all-time balance low
Max DD in percentage = (All-time balance high – All-time balance low)/(All-time balance high)×100
In Forex, Why Is It Crucial to Manage Drawdown?
Knowledge of the Drawdown is crucial when assessing the potential for loss in a trading account.
- The potential for drawdown in a trading account equals drawdown exposure to market volatility.
- The greater the drawdown, the greater the potential for complete account loss.
When investing in a portfolio or copying a trading account, the first step is verifying the drawdown of the copied portfolio or account. Pro traders aren’t interested in maximizing earnings but rather in minimizing losses.
Professional forex traders’ results can be evaluated by calculating their absolute and relative drawdown.
What Is Approximately Drawdown Percentage Best Suited?
This is based on the amount of your trading account. Keep your drawdown under 6% at all times if your account balance is significantly more than 5 or 6%, which is the standard range. For smaller accounts, a drawdown of 15% to 20% is considered safe, whereas a drawdown of more than 20% is dangerous.
When your trading account experiences a drawdown, it can significantly affect your career. Because of this, maintain your concentration to guarantee your safety and keep your equilibrium. Losing a portion of an account is preferable after making a significant profit.
The Drawdown of a Forex Trading Account and How to Manage It
You’ll need a solid risk management approach to control drawdown. Managing risk entails deciding how much to bet on each trade.
You can’t count on always coming out on top in trading. Sometimes you’ll win, and other times you’ll lose. There is always the risk of experiencing a string of losing trades that will have a devastating effect on your trading performance and trading capital.
You can protect yourself from this potential outcome by sticking to a strict risk management plan in which you only risk 2% of your account on each deal. You can use this to better control your drawdown. It’s true that even if you suffer a string of four consecutive trade losses, your drawdown will only be 8%. It is simple to get back. However, if you’re only investing 5 or 10% of your account, it’s easy to wipe yourself out emotionally.
Always look at the portfolio’s drawdown before putting money into it. You can use it to examine the portfolio’s level of risk. Drawdown can be minimized in numerous additional ways. Formulate risk tables on a weekly and monthly basis. For a small account, the maximum drawdown should not exceed 6% per week and 10% per month. Reducing drawdown and emotional distress is another benefit you’ll reap from doing this.
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Source: Forexbee