The foreign exchange market can be a complicated place, with a myriad of components to consider. With the forex market being so large– NASDAQ reports that more than five trillion dollars are traded on the forex market on average each day– forex traders need to understand all the terminology.
Drawdown is one of those important pieces of terminology for forex trading. It’s just as important to understand as margin, leverage, currency pairs, and other standard forex terms. This article introduces drawdown and explains what it means when it comes to forex trading.
What Is The Definition Of Drawdown?
A drawdown is when a forex trader loses equity in their account in a trading session. In the foreign exchange trading market, it’s the difference between the high point in the trader’s account balance and the subsequent low point of their account balance.
This difference displays a loss of capital due to losing money on trades. If you don’t lose money on a trade, then you don’t have a drawdown.
Example Of Drawdown
Let’s take a look at a hypothetical drawdown example to demonstrate the concept.
In this scenario, a forex trader has $100 in their account. They make multiple forex trades throughout the day, but they lose money, and their total balance drops to $80. This loss of $20 is a drawdown. In other words, the forex trader has a $20 drawdown.
Usually, drawdowns represent the losses for a single trading session and not a single trade.
Many traders, especially those new to the forex market, become discouraged after losing a trade or having a significant drawdown. However, if there is always hope for recovery.
Recovering From A Drawdown
Losing money on trades can be disheartening, but you can’t win them all. However, if you have reasonable risk management procedures, you will prevent yourself from having a significant drawdown.
All traders will have their ups and downs, as that is how the system goes. Even well-renowned traders, like the famous stock investor Warren Buffet, experience drawdowns. But through excellent risk management, their wins far outweigh their losses.
Traders in the forex market are constantly searching for an edge. Developing a system to build and maintain an edge is vital in the forex market. However, even with an edge, there will still be losses and drawdowns.
For example, let’s say that a trader develops a trading system that is 70% profitable. Although the edge is excellent, there is still a 30% loss to keep in mind. The trader may lose their first 30 trades but win their next 70. Although the initial 30 losses can be deterring, the following 70 wins make up for those losses.
This example demonstrates the importance of risk management. It boils down to the fact that drawdowns are simply part of trading.
Traders who develop a detailed trading strategy are much more likely to withstand periods of significant losses.
Learning Curve From A Drawdown
Drawdowns in the forex market are almost a certain inevitability for all forex traders. When traders find themselves in these situations, they should try to learn from their loss and fine-tune their plans to mitigate possible mistakes in the future.
With that said, the forex market is volatile and unpredictable, which means traders cannot avoid some losses. As with all trading, there is an inheritance risk of losing money no matter how solid you think your trade is.
So, forex traders should plan for losses, never put all their eggs in one basket, remove emotions from their trades, know when to walk away, and have a detailed plan for risk management.
Risk management plays a considerable role in preventing significant drawdowns, and a trader’s rules should outline their strategy for navigating such losses.
The Risks of Leverage
Many traders will use leverage to open trade with more cash than they own with the hopes of making more money off the investments. In other words, leverage is the funds a trader borrows to increase their trading position on the forex market.
For example, if a trader has 10x leverage, they can trade 10x the amount of cash they actually have in their account. So, they can trade $1,000 while only having $100 in their account.
Since they invest 10x more cash than they could have without leverage, they also make 10x more money off the investment if it does well (minus broker fees and interest, of course).
The use of leverage can be lucrative in some cases and amplify profits, but it also can significantly increase losses on bad trades.
In cases where traders use excessive leverage, problems are bound to come up. Excessive leverage makes it hard for the trader to recover from the losses and maintain the necessary margin to keep the trade open.
In some cases, the effects may be as drastic as losing the entire account within seconds. Additionally, a significant drawdown, like 70%, will put the trader in a substantial hole.
This means they will have to make over 100% return off their smaller capital just to break even with their original position.
After significant losses, some traders tend to become much more careless and aggressive in their trades, casting caution to the wind in hopes of hitting it big and making huge gains to offset their tremendous losses.
This usually does not end well and leads to significant losses and unwillingness to give up a losing trade.
What Is Maximum Drawdown In Forex?
Maximum drawdown (MDD) is the maximum peak to trough decline in the trader’s account.
The peak is the all-time account equity high, while the lowest trough is the all-time account equity low. Essentially, the maximum drawdown measures the difference between the highest and lowest equity in the trading account’s lifespan.
To calculate MDD, you subtract the peak value from the trough value, then divide that by the peak value.
For example, let’s say a trough value is $550, and the peak value is $3,000. In this case, the MDD would be:
$500 – $3,000$3,000 = -81.67%
What is Absolute Drawdown in Forex?
Absolute drawdown is the size of the loss relative to the initial deposit. It goes hand-in-hand with maximum drawdown. It’s your initial investment minus the minimal equity in your portfolio.
To better understand absolute drawdown, let’s look at the following example:
Let’s say a trader has $100,000 in his trading account. Without incurring any drawdown, the trader’s account equity surges to $170,000.
However, the trader experiences a few bad traders, and the account balance plummets back down to $100,000, which is the same amount the trader had at the start.
Therefore, the absolute drawdown is 0 because the difference between the initial deposit and the account equity trough is zero ($100,000 minus $100,000).
However, if the same trader lost more money and their equity dropped to $90,000, their absolute drawdown would be $10,000.
Why Is It Important To Keep Drawdown Controlled?
Money management skills are a crucial part of forex trading. It may seem like common sense, but it doesn’t go without saying that keeping drawdown under control is vital for forex traders to remain profitable.
Drawdowns are a common part of all types of trading, and failing to recognize, learn, and adapt from them will only lead to more issues and deeper losses.
Drawdown happens for several reasons, but most commonly are from bad trades. Even just a single bad trade can lead to drastic drawdowns. But if you use proper risk control, you’ll never have a significant drawdown from a single forex trade.
Even experienced traders have drawdowns. Regardless if you’re an expert or novice forex trader, a strategy must be in place to help mitigate your risk and plan the best course of action after and during a drawdown.
Strategies To Use
To help manage drawdowns, all forex traders should use the 2% rule.
The 2% risk management rule mitigates risk by only ever using no more than 2% of their capital on any forex trade. Traders should avoid allowing their emotions to take control after a drawdown, as it can lead to further issues that complicate the problem.
Focus on one trade at a time. If you focus your attention on one trade and always follow the 2% rule, you will keep your level of risk at 2% per trade. As such, you will never lose more than 2% of your equity on one trade.
Traders should also consider utilizing a stop-loss directly on their account balance. A stop loss is automatic and helps limit risk or protect a portion of the trader’s existing profits in a trading position.
Ranking trades based on profitability also can help mitigate risk levels, as can setting a daily loss limit.
Traders also can use a guaranteed stop-loss order, also known as GSLO. The GSLO functions to protect trade by ensuring that the trader’s stop-loss is executed at the trader’s outlined specific price without any slippage.
Protect Yourself From Drawdowns
A drawdown is the loss of equity in a trader’s account in a single trading session. To avoid significant drawdowns, forex traders should have an established risk management practice, like using the 2% risk rule to ensure they never have a significant drawdown from a single forex trade.