Updated on March 30, 2023
One of the fundamental strategies for being a successful forex trader is managing drawdowns, which is why this article explores the question: what is drawdown in forex? A drawdown refers to a decline in the amount of capital in a trader’s account. It is essentially the variance between the peak or high point and the next dip or low point in the balance of accounts.
Traders represent it as a percentage between the peak (high point) and the trough. Drawdowns are essential when it comes to measuring the historical risk of different investments, comparing the performance of different funds, or monitoring an individual trader’s performance.
Although the saying goes, “patience is a virtue,” for any forex trader, too much patience can be disastrous for their portfolio. For instance, if you invested a substantial amount of money, $100,000, in a highly risky or volatile portfolio. Your account would undoubtedly experience ups and downs, which reflect in the account balance. If the account balance dips by $90,000, but a previous upswing had your account at the peak of $120,000, and yet your original capital investment was $100,000. The drawdown would amount to $30,000 ($120,000- $90,000).
How to calculate drawdown?
Drawdown is typically measured over a specified time period and can be represented as a currency figure or a percentage;
Drawdown (DD) = ((Pmax – Pmin)/ Pmax)) * 100
With Pmax being the Peak price
Pmin being trough price
How to Measure Drawdown
Traders analyse drawdowns in absolute, relative, and maximum terms. Using a top-down approach, it is possible to analyse the past performance of a trading strategy by evaluating the absolute drawdown, relative drawdown, and maximum drawdown.
The different types of drawdown can help traders determine the potential loss they are likely to incur using a particular trading system.
A relative drawdown is the difference between the maximum equity high and the maximum equity low. It is an unrealized loss. Drawdowns remain temporary as long a trader holds on to their position. However, once they become realized, a stop loss is triggered or the position is closed.
For example, suppose a trader opened two positions with EUR/USD currency pair and an account balance of $10,000. If, in the first 1 hour, the account equity dips to $9,500, then recovers to $10,500 in the next hour. Those two positions would represent the minimum and maximum values, respectively. The difference between the two is the relative drawdown.
This refers to the maximum peak-to-trough decline in a trader’s account balance. The maximum drawdown represents the distance between the highest and lowest account equity value over the entire account trading period.
For example, suppose a trading account climbs from $10,000 to $30,000 within a few months. During this interval, the account balance might experience many declines, but if the maximum decline amounted to $7,000. The maximum drawdown would be $23,000.
Maximum drawdown= all-time high balance- all-time low balance
This drawdown illustrates how big the loss is in relation to the initial capital deposit. It can only be measured when the account balance dips below the initial deposit.
For example, suppose an account drops below the initial deposit of $10,000 to $7,000. The absolute drawdown would be $3,000.
Common causes of drawdowns
Trading is not for the faint-hearted and has often caused many traders to lose control, make bad decisions, and pull out too early or, on occasion, too late. Some of the common causes of drawdowns include;
- Poor/ no risk management strategy.
- Being too greedy for big gains.
- Fear of losing money.
- Over-trading or, in some cases, revenge trading.
- Trading with too much leverage.
When a trader experiences a large drawdown, there’s always a high risk that the losing streak will continue. Therefore it is often advised that they take a break, eliminate the negativity and only resume with a calmer mind. Alternatively, they are advised to use a demo account until their confidence is restored.
For a trader to be successful, they have a strategy to manage their drawdown. Drawdowns are the difference between the peak and trough of trading account balances and can be evaluated as relative, maximum or absolute drawdowns. Drawdowns can’t be avoided, as every trader will experience them for various reasons, but with a winning strategy, they can be mitigated.
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