Drawdowns, or account losses, are a natural part of trading, but when left unchecked, they can lead to financial losses. Employing strategies to mitigate drawdowns can help preserve capital and sustain long-term accomplishment in forex trading.
In this article, we will explain what drawdowns exactly are and how to avoid them in forex trading.
What is drawdown?
Drawdown is the reduction in a trader's account balance from its peak value. It specifically refers to the decrease in the total value of a trader's account from its highest price point to its lowest price point over a given period. This decline reflects the losses incurred during the trading process.
For instance, let's assume a trader initially has a trading account balance of $10,000, and the account balance drops to $8,000 after a series of trades. The drawdown, in this case, would be $2,000. This $2,000 reduction signifies the losses incurred during the trading period.
There are five main types of drawdowns:
- Equity drawdown: This is the real-time reduction in a trader's account balance, including unrealized and realized losses.
- Historical drawdown: This is a retrospective analysis of the maximum reduction in an account balance over a specific trading period. It provides a historical perspective on the worst-case scenario a trader has experienced.
- Relative drawdown: It measures drawdown as a percentage of the highest balance ever recorded in the trading account, providing a proportional perspective on losses.
- Absolute drawdown: This quantifies drawdown in monetary terms, representing the actual Dollar value of the reduction from the highest account balance to the lowest point.
- Floating drawdown: It reflects the reduction in account balance while trades are still open, accounting for unrealized losses or gains, offering insight into potential losses if those trades were closed at the current moment.
How to measure drawdown in forex?
1- Identify the highest balance: Determine the peak or highest value of the trading account. This is usually the starting balance or the highest point the account has reached.
2- Monitor the current balance: Keep track of the account balance over time, considering both realized and unrealized gains or losses.
3- Calculate the drawdown: A trader can express this as a percentage (relative drawdown) or in monetary terms (absolute drawdown).
- Relative drawdown: Calculate the drawdown as a percentage of the highest balance. It is expressed as: (Highest Balance - Lowest Balance) / Highest Balance * 100.
OR
- Absolute Drawdown: Calculate the drawdown as the actual monetary decrease from the highest account balance to the lowest point, expressed as: Highest Account Balance - Lowest Account Balance.
4- Evaluate risk tolerance: Compare the drawdown calculated to the risk tolerance. Assess whether it falls within the acceptable risk limits or not. If the drawdown exceeds acceptable risk limits, traders should adjust their strategy, reassess their risk tolerance, strengthen risk management, or seek professional guidance to protect their capital.
How to control drawdowns in forex?
Implement a drawdown cap
Setting a drawdown cap means defining the maximum allowable percentage of loss one's trading account can endure before a trader can take an action. For instance, a trader might decide that a 10% drawdown is their limit. When the account's cumulative losses approach or reach this threshold, it triggers a pause in the trading activities. During this time, traders can reevaluate their trading strategy, identify potential issues, and make necessary adjustments to prevent further losses.
Use a stop-loss
A stop-loss is a risk management tool that enables traders to predetermine the price level at which a losing trade will be closed. By setting a stop loss for each trade, traders establish a clear exit point to limit potential losses. This ensures that even if a trade moves against them, traders will not endure catastrophic losses, as the trade is automatically closed when it reaches the specified stop loss level.
Set a cap on risk per trade percentage
It involves deciding the maximum percentage of the trading account balance that traders are willing to risk on a single trade. For example, if traders choose a 2% risk per trade, it means traders will not allocate more than 2% of their total account balance to any individual trade. This risk management practice prevents any single trade from significantly impacting their account, reducing the potential for large drawdowns.
Set a positive risk/reward ratio
When a trader enters a trade, they should establish a risk/reward ratio that dictates the potential gain compared to the potential loss. A common ratio is 2:1, meaning traders aim to make twice the amount they are risking. By consistently using a positive risk/reward ratio, traders ensure that their gaining trades outweigh their losing ones, helping to limit drawdowns.
Consider periodic withdrawals
Regularly withdrawing gains from the account helps protect trading gains and reduces overall risk. For example, if a trader has achieved a certain gain target or their account has grown significantly, they can withdraw a portion of those gains to protect their capital. This withdrawal strategy protects their capital against market downturns.
Avoid revenge trading
Emotional responses to losses can lead to impulsive and irrational trading decisions, often referred to as revenge trading. Instead of trying to recoup losses by taking excessive risks, it is essential to maintain discipline and stick to the trading strategy. Emotional trading can exacerbate drawdowns, so controlling one's emotions and avoiding making impulsive trades out of frustration or anxiety is crucial.
Managing drawdowns in forex is crucial
Limiting drawdowns protects trading capital and maintains a sustainable trading experience. Excessive drawdowns can lead to account depletion and hinder future growth. However, strict drawdown limits might also result in missed opportunities, as some risk is inherent in trading. Striking the right balance is crucial for optimum trading.
