What is Drawdown in Forex Trading | LiteFinance (2024)

Forex trading can result in a profit or a loss. Depending on the trading career, experience, knowledge, and other factors, a trader can be called successful or not. But regardless of the final result, everyone faces a drawdown.

Drawdowns occur for any trader; without them, it is simply impossible to trade in Forex. Therefore, let's figure out what it is and how to turn a drawdown into profit.

What is drawdown?

The first thing every trader needs to know is that there is no need to be afraid of drawdowns. This is an absolutely natural state in the trading business.

A drawdown is a peak to trough decline in funds on the trading account as a result of losing trades. In other words, a drawdown occurs when trading yields a loss. A drawdown can be floating (temporary) or fixed (permanent).

A temporary drawdown is a situation when losing positions have not yet been closed. Permanent or fixed drawdown occurs when losing positions are closed. If a floating drawdown does not affect the account equity, then a fixed drawdown reduces the balance.

Example of a floating drawdown

Your account equity is $5,000, and you bought 10Walt Disney shares for $100 each. Some time later, the share price fell, and now they are trading at 90 USD. Since you bought shares more expensive, you have a temporary drawdown of 10 USD per share.

Thus, the temporary funds on the account are 4900 USD, while the balance is unchanged and equals 5000 USD. If the price reverses and starts rising, the drawdown will decrease.

Example of a fixed drawdown

Your account equity is $500, and you bought 10 Walt Disney shares for $100 each. Some time later, the share price fell, and now they are trading at 90 USD. Since you bought stocks more expensive, you have a temporary drawdown of 10 USD per share. You assume that the price will fall further, so you exit the losing trade. After closing your positions, your balance has changed, and now you have 4900 USD on your account.

Thus, the floating drawdown turned into fixed.

How is drawdown calculated?

From the examples above, you can understand exactly how the drawdown is calculated. Most often, traders calculate two types of it: drawdown from initial funds and maximum drawdown.

Initial drawdown

Base Drawdown = ((Initial Account Equity - Minimum Deposit Value) / Initial Account Equity) × 100%

Base drawdown = ((5000 - 4900) / 5000) × 100% = 2%

Thus, our basic drawdown relative to the balance funds before entering the trade is 2%.

Maximum drawdown

The maximum drawdown is a temporary indicator that shows the difference between the peak and the subsequent trough on an investment or trading account.

Maximum Drawdown = ((Max Account Margin - Minimum Account Margin) / Maximum Account Margin) × 100%

Maximum Drawdown = ((5500 - 4500) / 5500) × 100% = 18.18%

Types of drawdown

There are several types of forex drawdowns as well as ways to record them. To more accurately determine what kind of drawdown a trader needs to calculate, there is an official classification.

1. Floating (temporary) drawdown when a trader has losing positions open.

2. Fixed (permanent) drawdown occurs when a trader fixes a floating loss and exits losing trades.

3. Maximum drawdown is the peak-to-trough decline for an investment or trading account during the whole period of trading.

4. Relative drawdown is the difference between the initial deposit size and the maximum loss (temporary or permanent) for the entire trading period.

5. Absolute (basic) drawdown is the difference in the trading account equity before and after trading.

Floating drawdown

A floating or temporary drawdown is a change in the trading account equity over time. This type of drawdown is also called a working drawdown since it occurs when there are open trading positions.

Example of a floating drawdown

You have 5000 USD on your balance, and you decide to buy ten shares ofRaytheon Technology at a price of 100 USD per share. Before entering a trade, the balance and equity are equal.

Two days later, the share price fell to 85 USD. Since the current price is below the purchase price, there is a floating loss of 15 USD per share or 150 USD. In this case, the balance will remain at 5000 USD, but the equity will drop to 4850 USD. The missing 150 USD is the floating drawdown.

To calculate the current drawdown, we use the standard formula:

Floating drawdown = Balance – Current equity

Floating drawdown % = ((Balance – Current equity) / Balance) × 100%

Floating drawdown = 5000 - 4850 = 150

Floating drawdown % = ((5000 - 4850) / 5000) × 100% = 3%

You should remember

A floating loss is a relative value. It doesn’t mean that the trader’s activity is unsuccessful; it means that the current price is not where you expect it to be. But in a minute, everything can change, and even a big drawdown can disappear. The optimal size of the floating drawdown depends on the trading strategy. However, if a drawdown exceeds 50%, one should do something.

Fixed drawdown

A fixed drawdown is a net difference in the trading account balance before entering a trade and after exiting it. Occurs when all unprofitable positions are closed.

Example of a fixed drawdown

You have 5,000 USD on your balance, and you decide to buy ten shares of Raytheon Technology at a price of 100 USD per share. Two days later, the share price fell to 85 USD. Since the current price is below the purchase price, there is a temporary loss of 15 USD per share or 150 USD. You decide to exit the trade at a loss to avoid further losses. In this case, your balance will decrease after the trade is closed and become equal to 4850 USD.

To calculate the fixed drawdown, we use the formula:

Fixed drawdown = Starting balance - Final balance

Fixed Drawdown % = (Fixed Drawdown × 100%) / Initial Balance

Fixed drawdown = 5000 - 4850 = 150

Fixed Drawdown % = (150 × 100%) / 5000 = 3%

You should remember

A fixed drawdown in Forex is an indicator that the trades you made were losing. The effectiveness of the trading system is assessed by the size of the fixed drawdown. According to the basic parameters of successful trading systems, the fixed drawdown should not exceed 20%.

Absolute drawdown

Absolute drawdown in Forex is the difference between the initial deposit and the largest equity loss. It occurs with the opening of the first transaction on the account and remains until the next increase. This is the most important and informative type of drawdown.

An example of an absolute drawdown

You had 5000 USD on your balance. As a result of transactions made during the month, the balance decreased to 4800 USD. Taking into account open positions, the account equity is 4700 USD. Some time later, the price went in the predicted direction, and the equity increased to 4850 USD. Since the absolute drawdown is the difference between the initial and the minimum value, it will equal 5000 - 4700 = 300 USD.

Based on the example, it is easy to derive the formula:

Absolute Drawdown = Initial Balance - Minimum Equity

Absolute Drawdown = 5000 - 4700 = 300

You should remember

The absolute drawdown shows the maximum loss relative to the initial investment a trader suffers. The smaller the absolute drawdown, the more efficient Forex trading strategy. Experienced and successful Forex traders try to ensure that the absolute drawdown does not exceed 10% of the initial funds.

Relative drawdown

Relative drawdown is a more common type of absolute drawdown. The difference is that the relative drawdown is expressed as a percentage. That is, it is the difference between the initial balance and the minimum equity, expressed as a percentage.

Relative drawdown calculation formula:

Relative Drawdown = (Absolute Drawdown × 100%) / Initial Balance

Relative drawdown = (300 × 100%) / 5000 = 6%

You should remember

Relative drawdown is the most used type of absolute drawdown by most traders. It is used when creating and testing trading strategies. This type of drawdown is also used in strategic investing to determine profitability.

Relative drawdown is often referred to as a "critical stop loss." When the planned level is reached by the relative drawdown, the trader may decide to completely close all transactions; otherwise, the margin call will be received.

Maximum drawdown

A maximum drawdown (MDD) is the maximum observed loss from a peak to a trough of a portfolio before a new peak is attained. Maximum drawdown is an indicator of downside risk over a specified time period. The maximum drawdown is often estimated by investors who choose a successful forex trader to copy.

An example of a maximum drawdown

Initially, you had 5,000 USD on your balance, and as a result of operations, it increased to 6,000 USD. After that, a period of temporary losses began, and the balance decreased to 4000 USD. However, after a while, Forex trading returned to normal, and the balance rose again, setting a new high of 7,000 USD. Since the maximum drawdown is calculated from the high to the low, it will equal 6000 - 4000 = 2000 USD.

Based on this, the maximum drawdown formula will look like this:

Maximum drawdown = Peak Value – Trough Value

Maximum drawdown % = (Maximum drawdown × 100%) / Peak Value

Maximum drawdown = 6000 - 4000 = 2000

Maximum drawdown % = (2000 × 100%) / 6000 = 33,3%

You should remember

The maximum drawdown will always be the largest of all the others, but you should not be afraid of this. A maximum drawdown of 30% or even 40% is normal when trading Forex. The most important thing is that Forex trading should be comfortable with such a drawdown. Another thing is the duration of the maximum drawdown. If it was formed within a short period of time, this may be a force majeure. But if it was formed for a long time, the trading plan should be adjusted.

Acceptable drawdown level

You can choose a trading strategy based on the drawdown size. To determine its effectiveness, a relative drawdown is used. Depending on the allowable level of relative drawdown, trading strategies are divided into:

1. Low-risk (Conservative)

Conservative strategies suggest minimum risk tolerance and slow but steady income. In low-risk strategies, a drawdown of no more than 15% is allowed, ideally no more than 10%.

2. Balanced

Balanced strategies are the most common in Forex trading. They perform well with drawdowns from 20% to 35%.

3. High-risk (Aggressive)

This type of strategy includes trading with high leverage, which means a high level of risk. In such trading systems, it is acceptable to receive drawdowns of up to 50%, and when using the Martingale strategy - up to 70%.

Using high leverage

A trader's aggressive approach is attractive for beginner traders due to their high potential profits. In such trading systems, leverage is always used, allowing you to earn a lot quickly. But it also has a downside: high risk. The higher the leverage, the higher the risk of loss. Do not increase the leverage if you are not ready to see half of your deposit in a drawdown.

Based on my experience, I can say that I often came across traders who made high profits from aggressive trading, but subsequent transactions completely nullified their deposits, destroying investment objectives. So, in such conditions, Forex trading is possible only for real pros, and 99% of beginners are likely to lose their deposit.

What you can learn from a drawdown

As the name implies, a drawdown is a loss, and it does not matter if it is temporary or fixed. So psychologically, we will perceive the drawdown negatively.

The presence of a drawdown tells us that our original plan is either on the verge of failure or has already failed. Therefore, a decision needs to be made.

If, when entering a trade, you assumed a loss of 10%-20%, then a drawdown in this range means that it is time to close the position.

Just remember the smallest loss you can get as a result of a mistake is the one you fix right away.

Why do you need to analyze the causes of drawdown?

If you get a drawdown that turns into a fixed loss, then Forex trading didn't go the way you wanted. If something goes wrong, it must be analyzed so that the loss does not repeat in subsequent transactions.

Drawdown analysis is an important element in evaluating a trading strategy. If, during a long period, the drawdown did not exceed the acceptable levels, the trading strategy works perfectly.

There are many reasons for drawdowns: from a common oversight to force majeure. If the drawdown is due to your mistake, take it into account and move on. If you do not know why the drawdown occurred, do not enter any more forex trades based on this signal.

Drawdown assessments

To correctly analyze the causes of drawdowns and draw correct conclusions from this, use a number of rules:

Set acceptable risk

Forex trading is a risk. Any transaction should begin with an assessment of its effectiveness and risk-to-reward ratio. This means that you must weigh all the pros and cons. And if the possible profit suits you, set the level of risk that will be acceptable to you. For example, if you want to profit 100% from your investment, a drawdown of 20% or even 30% would be acceptable.

Set Stop Loss

To prevent a drawdown from destroying your deposit, set a stop loss. The market is irrational, and anything can happen: crises, collapses of banks, economies, and much more.

Use risk management

Risk management is a set of measures to bring a transaction or deposit out of losses. If there is a drawdown, but its value is not critical, you can try some methods of many traders. For example, you can try setting a trailing stop or hedging. I would recommend testing any trading method on a demo account or a Forex simulator before you start trading with real money.

Exit losing trades

It may seem strange, but if there is a deep drawdown and you didn’t expect it, close the position. If you exit a losing trade, you can cover the loss by the following trades. If you just wait and see, hoping the price will reverse, you can lose all your deposit.

Losing streak

Psychology in trading is the most important part. One can imagine how a trader is morally pressed by a series of several drawdowns or losses in a row.

Let's look at this situation from a different angle. If a trader has a losing streak, several unsuccessful trades in a row, this is not always a bad thing. Firstly, it shows that the person controls the risk and does not allow one bad trade to destroy the entire deposit. With proper risk management, the potential for profit is always higher than the potential for loss. So, one profitable transaction will compensate for the past performance.

From my own experience, I can say that a losing streak happens to everyone. And if this happens, you should not turn off the path. Believe in your strategy, and it will bring you profit. Always remember the effectiveness of a strategy is determined by the final result. It doesn't matter if it's the stock market or the Forex market. You can make 20 losing trades at the beginning and 30 profitable trades at the end. The end result will be in your favor.

How to reduce Forex drawdown?

Imagine the situation: you have calculated everything in advance, but there is still a drawdown. What to do to minimize the losses? Let us look at several options:

Exit the trade

The minimum loss is the one that was closed immediately. If there is a drawdown and it exceeds the acceptable level, and your skills and experience do not allow you to correct the situation on your own, close the position. Exit the trade, analyze the reasons, and try to avoid the loss next time. To make a profit, each new transaction should not be a continuation of the old one but a new one.

Trailing stop

If you are unwilling to close the losing trade, you can try to correct the situation. The first tool is an automatic loss limiter. But it should not be a simple stop loss, which will just exit the trade. You should set a trailing stop, which will follow the price up to the profit. A trailing stop works like a stop loss on a loss and a take profit on a profit. Upon reaching its level, the transaction will be closed. If the drawdown starts to decrease, it will follow the price, reducing the maximum loss.

Hedging

Hedging means entering an opposite trade for the same amount as the losing one. If the position is opened using the same instrument, the position will be locked. It will “block” both loss and profit but will give you time to think about a more detailed plan.

Hedging is a more complex action. Usually, different retail investor accounts are used for hedging, but one instrument. As a result, you will lock the position, but since these are different accounts, transactions do not block each other. You can also hedge using opposing instruments. For example, a loss yielded by theEURUSD drop can be hedged with a profit from theUSDCHF rise, as they will move in different directions.

Conclusion

Summing up, there are several takeaways. A drawdown is a natural state of a trading account or trade. You shouldn’t be afraid of drawdowns, you should be able to control it. For successful trading, you need to know what is an acceptable drawdown before entering a trade. The most important thing in trading is not how low your drawdown is but how much capital you earned.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.