What is a Forex drawdown, and how to manage it?
What is forex drawdown? What are the types of drawdown accounts? How is the calculation of the drawdown of the deposit? What should be the maximum drawdown? How to recover account after drawdown?
Hello, gentlemen, traders! Learning how to manage your Forex deposit drawdown is more important than profit. If you do not know how to control the drawdown in trading in the Forex market, then you can lose your entire deposit. Our team of traders has developed this guide to explain the importance of drawdowns in trading and help you deal with drawdowns.
For those who have not yet chosen a broker, we suggest that you look at our Forex brokers rating and read the feedback from traders.
Trading Drawdown Value
Beginners and professional traders tend to experience large drawdowns in their trading accounts. The psychology of large Forex drawdowns is very easy to understand. Traders prefer to avoid losses instead of trying to profit from trading. In other words, trade losses can have a deeper impact on the thinking of traders than the pursuit of profit.
What does this have to do with forex drawdowns? The fact is that traders who are losers, rather than accept defeat, are most likely to do one of the following:
- Keep a loss in the hope that the transaction will unfold in his favor.
- Increase risks in order to try to recover deposit losses.
These are all signs of an inability to accept defeat in trade. This is one of many reasons why traders lose much more money than they should.
An important skill that every trader should have is the ability to cope with the drawdown of a deposit. Trading loss is only a temporary setback. The right trading that you need to learn is to focus on winning trading.
In this article, you will learn what steps you need to take to maintain a low drawdown when trading on any type of market (Forex, stocks, products, futures or cryptocurrencies).
What is a Forex drawdown?
In trading, the drawdown refers to the peak decline during a certain period for your trading account. In other words, the difference between the peak of the account balance and the lower point of the account balance is defined as the drawdown.
For example, if your Forex trading account had $ 5,000 and you lost $ 1,000, then you had a drawdown of $ 1,000 or 20%.
In fact, Forex drawdown is another risk metric for evaluating the effectiveness of the trader.
The maximum drawdown that you can afford on your Forex account comes down to your personal risk management. If you take a greater risk, then the drawdown can be quite high. Conversely, if you take less risk, you will receive a small percentage of drawdown. In this case, a 10% risk per trade may not be a good idea.
If you often reach maximum drawdown, this is a sign that:
- You need to reduce the risk per trade.
- You must understand your trading strategy and find out what is going wrong.
Do you know that even the most prestigious hedge funds on Wall Street have provided the maximum drawdown that they may have. The standard maximum drawdown in the investment world is about 20%. The maximum drawdown will vary depending on the assets traded.
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Calculation of the drawdown of Forex deposits
There are several dimensions of drawdowns in Forex trading:
- maximum drawdown;
- relative drawdown;
- absolute drawdown.
The maximum drawdown can be calculated as the ratio of the maximum equity to the difference between the maximum and minimum equity for all time.
In the investment world, loss protection means more than profit growth. The drawdown of a Forex deposit is of great importance, as it shows how reliable your strategy is.
Recovery from a large drawdown or major loss is time consuming and can lead to emotional exhaustion.
For more information, please refer to the table below. The first column shows the size of the drawdown from the deposit, and the second shows how much you should earn to compensate for your losses.
There is a common misconception, especially among novice traders who think that if you experience a 50% drawdown, you will need to earn 50% to recover your capital. This is not true. You will need a 100% return to return your capital to the breakeven point. By any measure, this is a lot.
So drawdown matters!
As the statistics showed, the most important thing is to protect your capital, because it is much more difficult to recover from a period of large drawdowns.
Trading examples with drawdown
Let's look at an example of a trading account with an initial balance of $ 10,000.
Suppose you have an advantage in the market, and you are pretty successful at earning Forex.
Below you can see the results of your trading strategy:
The question is, what is the maximum drawdown of this strategy?
The way to determine the maximum drawdown is very simple:
- Take the largest balance before your account deposit starts to decline again.
- Take the smallest equity before it starts moving higher, passing the upper mark in step 1.
Using the above rules, we can calculate the first drawdown.
See the image below:
The first drawdown was $ 2,500. But is it the maximum drawdown? We don’t know that yet.
Let's continue and apply the same rules, moving forward with our hypothetical account balance efficiency:
The next drawdown is $ 3,400, which is also the biggest drawdown in this series.
Currently, thanks to advances in online trading technologies, your Forex broker will provide you this data for free.
When evaluating performance, drawdown in the trading system is one of the first statistics that you should pay attention to.
Below you will find a trader’s manual on working with drawdown periods.
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How to keep Forex drawdown under control?
The secret to long-term survival in Forex trading is to maintain and increase your trading account. You can earn and lose money - this is a natural process, but your account should not approach zero.
Here's a simple trading secret that all Wall Street traders know. You control the drawdown in Forex trading using the correct position size and risk management strategy.
Short-term drawdowns are acceptable and manageable, but you should not be in a situation where one transaction destroys 50% of your account or even worse. Large drawdowns are often a side effect of the fact that traders cannot control their emotions in the market. You can learn several tricks to deal with a drawdown as a pro.
Three simple rules for restoring an account after a drawdown
The first step in dealing with drawdowns is to acquire the right thinking that fosters trading.
Want to learn how to survive the daily drawdown, which is almost inevitable, and all traders must go through it? Statistics have shown that most of your life career will be spent on drawdowns.
If you spend a lot of time in the drawdown, it is important to learn how to quickly recover the account after drawdowns. Based on the foregoing, here are three trading rules you should use to recover from drawdowns:
Rule 1. Set the maximum drawdown for your trading strategy. Using effective testing methods, you can determine the maximum drawdown of your trading strategy. As a rule, the maximum drawdown should not exceed 20% of your deposit. If you have received big losses, then do not trade on this day. And do not make the main mistake - win back all your losses in one transaction. You will greatly exceed the risks and may lose the entire deposit.
If you cannot learn to master the discipline, then you better stick to algorithmic trading and let the adviser do the work for you. Automated trading often eliminates the counterproductive emotional decisions inherent in manual trading.
Rule 2. Reduce the size of your position. Another thing you can do to deal with drawdowns is the risk of a trade or position size. Contrary to popular belief, which teaches you to increase your risk so that you can speed up the recovery process, this trading method is very damaging to the balance of your account.
Many traders use aggressive pyramiding or the method of averaging deals in their trading when all new deals are opened in the direction of a losing position. Of course, if the price goes in your direction, then you will not only win back your losses, but you can also make good money. But in most cases, you simply lose your deposit.
The legendary trader Richard Dennis in his strategy Turtles dealt with drawdowns as follows. When drawdowns occurred, he reduced the risk per trade from 2% to 1.6% and continued to reduce the size of his position if the drawdown expanded.
Rule 3. Increase your risk-reward ratio. To avoid drawdowns faster, you need to learn how to increase your risk-reward ratio. One of the most effective ways to improve this ratio is to improve your entry strategy.
Having the best time to enter a trade, you can hold stop loss very hard , which further limits your losses. With a risk to profit ratio of 1: 3, you can avoid the drawdown period fairly quickly, even if your profit ratio is still very low.
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Thus, Forex drawdown is the most important risk metric because a large deposit drawdown can force you to change your trading strategy if you have too many consecutive losses or if our losses last too long. A Forex drawdown can literally kill your account if you do not know how to recover from a drawdown period. The only way you will never run into drawdowns is to stop trading. You must accept the reality that a drawdown in Forex trading is inevitable.
There is no such thing as risk-free profit. You must work competently to not only make a profit, but also to keep it. Based on the foregoing, you need to remember only three rules of drawdown trading if you want to trade as a professional:
- Set the maximum drawdown.
- Reduce the size of deals.
- Increase your risk / reward ratio.
Profitable to you trade!
See also the article "What is the Forex market liquidity?".