What is drawdown in Forex? Understanding the term’ drawdown’ is crucial for anyone stepping into the world of Forex trading.
It’s a term that might sound intimidating, especially to new traders, but it plays a significant role in gauging trading performance and risk.
This article will explore what drawdown in Forex is, why it is crucial, and how it can influence your trading decisions.
By clearly understanding drawdown, you can better navigate the turbulent waters of Forex trading and safeguard your trading capital.
- What is The Meaning of Drawdown in Forex
- How Drawdown is Calculated
- How Much Money Should You Put At Risk Per Trade?
- Why It's Important to Keep Drawdown Under Control
- The Psychological Impact of Drawdown in Forex Trading
- How To Regain Your Breakeven Point?
What is The Meaning of Drawdown in Forex
Drawdown in Forex refers to the decline in your trading account from a trade or a series of trades during a specific period.
It’s the difference between a relative peak in capital minus a relative trough.
But how exactly is it calculated, and what does it mean for you as a Forex trader? Let’s delve deeper into these aspects.
Imagine your trading account hits a high of $10,000, then drops to $7,000 due to a series of losing trades.
The drawdown would be the difference between the high and the low, in this case, $3,000 or 30%.
How Drawdown is Calculated
Calculating drawdown is pretty straightforward. It’s expressed as a percentage and is calculated by taking the difference between a relative peak in your balance and a following trough (lowest point), then dividing that number by the peak.
This percentage represents the loss you’ve sustained from the peak.
Experienced traders generally place a high value on risk management when trading, so they meticulously monitor the health of their trading positions and portfolio.
Drawdowns help you understand the long-term viability of your trading strategies and allow you to take proactive positions before your drawdown size becomes unsustainable.
To progress from a losing trader to a successful forex trader, you must first learn how to control your drawdown.
Surviving Losing Streaks
We are always looking for an EDGE in trading. That is why traders create systems in the first place. A trading system that is 70% profitable sounds like a great advantage to have.
But does your trading system being 70% profitable mean that you will win 7 out of every ten trades you make? Certainly not!
How do you know which 70 of the 100 trades will be profitable? For example, you could lose the first 30 trades in a row before winning the next 70.
That still leaves you with a 70% profitable system, but you must ask yourself, “Would you still be in the game if you lost 30 trades in a row?”
This is why risk management is critical. You will eventually go on a losing streak, no matter what system you use.
Even professional poker players who profit from poker experience terrible losing streaks. But the smart ones still end up in profits. This is because good poker players practice risk management as they know they will not win every tournament they participate in.
Instead, they only risk a small portion of their bankroll to survive losing streaks.
The key to being a successful forex trader is devising a trading strategy that allows you to weather these periods of large losses. Risk management rules should also be part of your trading strategy.
Only risk a small portion of your “trading bankroll”, that is, your trading capital, to survive losing streaks.
How To Handle Drawdown In Forex Trading
It takes money to make money, but how much money does it take to start trading? The answer largely depends on your approach to your new trading venture.
It differs from one person to the next. Drawdowns are a fact of life and will happen to you at some point.
The more you lose, the more difficult it is to return to your original account size. This is all the more reason why you should take every precaution to safeguard your account.
I hope it has been drilled into your head that you should only risk a small percentage of your account on each trade to survive losing streaks and avoid a large account drawdown.
Large drawdowns usually mean the end of your trading account. The lower the risk on a trade, the lower the maximum drawdown.
The more money you lose in your account, the more difficult it is to return to breakeven. This means that you should only trade a small portion of your account.
The smaller the size, the better. Less really is more.
How Much Money Should You Put At Risk Per Trade?
That’s an excellent question. Try to keep your risk to no more than 2% per trade. However, that figure could be a little exaggerated especially if you are a newcomer to forex trading.
There is a significant difference between risking 2% of your account and risking 10% of your account on a single trade!
If you had a losing streak and only lost 19 trades in a row, you would have gone from starting with $20,000 to having only $3,002 left if you risked 10% on each trade.
You would have lost more than 85% of your account! You would still have $13,903 if you had only risked 2%, which is only a 30% loss on your account.
Of course, you don’t want to lose 19 trades in a row, but even if you only lose five trades in a row, consider the difference between risking 2% and 10%.
Even if you risked 2%, you’d still have $18,447. You would only have $13,122 if you took a 10% risk. That’s less than you’d have gotten even if you’d lost all 19 trades and only risked 2% of your account!
The point of this illustration is that you should set up your risk management rules so that if you experience a drawdown period, you will still have enough capital to stay in the game.
Can you imagine losing 85% of your account? To get back to break even, you’d have to make 566% of what you’ve got left! You do not want to be in that situation, believe me.
2% or Less!
It is recommended that you use no more than 2%. “2% or less” per trade is a good rule of thumb for everyone to follow.
I emphasize “guideline” because it is dependent on factors other than your experience, such as your trading system–specifically, how frequently it takes a trade.
The less you want to risk per trade, the more currency trades you take per timeframe that you focus on. Finally, don’t forget to account for changing market volatility.
Volatility may necessitate changes to your entry and exit points.
Why It’s Important to Keep Drawdown Under Control
Drawdowns are an unavoidable part of trading, and they occur more frequently than you might think. It is normal for our trading accounts to experience a drawdown in this regard.
If we can’t get away from a drawdown, we must learn how to keep it under control. This is where proper money management strategies come into play, allowing forex traders to recover from large losses and keep moving forward.
Dealing with a drawdown can be mentally taxing. So, before looking at ways to control a forex drawdown, you must first understand why drawdowns occur.
Why Does Drawdown Occur?
There are several reasons for the forex drawdown, but the most common ones are as follows:
- A single bad trade can result in a significant loss.
- Taking an unsuitable level of risk in relation to the funds in your trading account
- Volatile markets can also result in large equity drawdowns.
- Unpredictable events, such as a black swan event or a flash crash, can result in significant drawdowns.
- Failure to employ risk management strategies to control drawdown
- Overtrading occurs when you enter too many trades and trade outside your trading plan.
- If you experience frequent drawdowns, your trading system may be ineffective.
The Psychological Impact of Drawdown in Forex Trading
Drawdowns can have a significant psychological impact on forex traders, especially beginner traders. But even experienced traders can be affected by the emotional stress associated with drawdowns.
Here are some ways in which drawdowns can affect a trader’s psychological state:
- Stress and Anxiety: Watching the value of your account decrease during a drawdown can cause a great deal of stress and anxiety. This emotional toll can cloud judgment and lead to poor trading decisions.
- Loss of Confidence: Drawdowns can lead to a loss of confidence in your trading strategy. This can result in second-guessing your approach, overreacting to market movements, or hesitating when opportunities arise.
- Fear and Panic: Severe drawdowns can cause fear and even panic. In such states, traders might make irrational decisions, like prematurely closing positions or risking more to try to recover losses quickly.
- Greed: In an attempt to recover from a drawdown, some traders might become overly aggressive, taking on more risks than they can handle, which can lead to further losses.
- Discouragement and Quitting: After experiencing a significant drawdown, some traders may feel discouraged and consider quitting trading altogether.
It’s essential to manage these psychological impacts effectively, and this can be achieved through the following:
- solid risk management strategies,
- maintaining discipline,
- Backtest your trading strategies
- having a well-tested trading plan, and
- Incorporating techniques such as meditation or other stress-management practices into your routine.
Remember, drawdowns are a normal part of trading and should be planned for, not feared.
How To Regain Your Breakeven Point?
To regain your capital after a drawdown, you must have a trading plan that risks only a small part of your capital. Keep in mind that you cannot influence the past. All you can do is learn from it and apply it in your future trades.
Here’s a table that shows what percentage you’d have to make to break even if you lost a certain percentage of your account.
|Loss Of Capital||% Required To Get Back To Breakeven|
You can see that the more you lose, the more difficult it is to return to your original account size. This is all the more reason for you to do everything you can to protect your account.
One suggestion is to use any of the trading tools on forexdominant.com. For example, the Profit robot strives to keep drawdown at the barest minimum through a risk management system built into its algorithm.
We hope you have it drilled into your head that you should only risk a small percentage of your account per trade to survive losing streaks and avoid a large drawdown in your account.
Remember that you want to be the casino, not a gambler!
If you want to be a successful forex trader who makes money over time and does not burn through your account quickly, you must keep the drawdown under control.
Drawdowns are an inevitable part of trading, and everyone will have to deal with them at some point.
If you really want to deal with drawdowns better, try incorporating some techniques taught in this drawdown trading guide into your trading plan.