As Forex traders, we all know and understand the importance of having good risk management when we trade in the market. The level of risk management used in trading is proportional to your success rates when it comes to trading. This would in turn benefit you down your trading journey, in time to come.
The Drawdown in Forex refers to the amount or percentage of account balance lost due to losing trades. It is calculated as the difference between the highest point and the subsequent low point of your account balance. As you have losing trades, you are experiencing drawdowns.
We shall talk a little more about what drawdowns are, as well as what you are able to do to minimize them when you trade.
Table of Contents
- 1 Drawdown in Forex Trading
- 2 How is Forex drawdown calculated?
- 3 What does maximum drawdown mean?
- 4 How to Improve Drawdown
- 5 Related Questions
Drawdown in Forex Trading
Defining Drawdown In-Depth
To allow you to understand further what a Drawdown is, let’s come up with a likely scenario.
With an initial account balance of $20,000, you enter a trade. However, the trade turns out to be losing, so your balance is not $18,000. This means that you have experienced a drawdown of $2,000. You can also say that you have a 10% drawdown, which means you have lost 10% of your account size.
This is a scenario that is rather probable. It is crucial that you understand that in trading, losing is inevitable. Drawdowns also help in future backtesting, as well as monitoring your trades.
Drawdown, Risk Management and Long-Term Trading
Drawdowns are a part of trading Forex and they pose a significant risk to Forex traders. If you encounter a bad trade, your drawdown experience could impact your account severely.
However, you are able to minimize them by having a proper trading plan, as well as having good risk management in your trading. Using a stop-loss as you enter new trades would help to limit the amount of drawdowns taken. These could save you from potential losses and enable you to continue trading in the long run.
Factors impacting Drawdown
One of the key factors that impact drawdowns is the amount of leverage used. Often, a combination of having too much leverage with a bad trade could lead to terrible consequences. Since leverage is about having to borrow money to conduct trades, using too much leverage when the trade is not to your advantage would result in a huge loss.
Other factors would include the trader’s attitude, either with them being overly confident, or overly aggressive when they trade. The trader could also be reluctant to accept the fact that their trades are losing. This could cause a snowball effect on their drawdowns, which could end their trading career.
Why is considering your drawdown important?
Drawdowns help you assess the long-term sustainability of your trading system so that you can work on improving your risk management techniques and trading system.. With the proper techniques, you would be able to break even more easily as compared to trading aggressively and using leverages while attempting to recover the losses.
How is Forex drawdown calculated?
The formula to calculate the drawdown percentage is the Drawdown Value (in dollars) over the Account Balance, converted into percentage by multiplying the value by 100%. We shall now discuss 2 possible scenarios, the first with a large drawdown and the second with a smaller drawdown.
In the first scenario, you have an account balance of $50,000. The value of every pip is 20 and the drawdown of pips is 1,000.
Drawdown Value (in dollars) = 20 x 1,000
Drawdown = ($20,000 / $50,000) x 100%
Therefore, the drawdown of this trade is a high 40%.
In the second scenario, you have an account balance of $20,000. The value of every pip is 15 and the drawdown of pips is 150.
Drawdown Value (in dollars) = 15 x 150
Drawdown = ($2,250 / $20,000) x 100%
Therefore, the drawdown of this trade is a much smaller 11.25% as compared to the first scenario.
What does maximum drawdown mean?
A maximum drawdown of a trade refers to the most amount of drawdown observed in your account until there is a new peak. It is mostly measured in percentages.
In other words, it is simply the greatest difference between the high and low of a trade. Its main purpose is to measure the greatest amount of losses, but without taking into consideration the frequency of losses and the recovery of losses.
Maximum drawdowns can help to indicate the risk of having a downside trade for a specific duration or time period.
How to Improve Drawdown
How to track drawdowns in your account
There are 2 different methods in which you are able to track the drawdowns for your trades. The first way to do it is by using your myfxbook account.
- Log in to your myfxbook account and select account.
- Under your account, you should see “Charts”. Select the Drawdown tab under Charts.
- Observe the highest point of the graph to determine the maximum drawdown of your trades.
You are also able to track the drawdowns in your account manually by using a spreadsheet such as Microsoft Excel or Google Sheets. How do you do this?
- Import all your trades into the spreadsheet by selecting the File button, then the Import option.
- Create a column for Balance, then add your profits into the balance for every trade.
- Create a second column for Percentage Change to track the percentage of profits or loss.
- Create a third column for Running Percentage Change and with the MIN function, search for the maximum negative number for the maximum drawdown.
Even if you are not using myfxbook, you are still able to easily track the maximum drawdown for your trades manually with the spreadsheet method.
Tips to decrease or mitigate drawdown
As mentioned earlier, you would need to have a good Risk Management technique as well as a solid trading plan to help you mitigate drawdowns when trading. We will now discuss a little bit more about how you are able to minimize and manage your drawdowns.
Reducing your risk when trading
What would happen if you lose many trades consecutively? You would know that this would result in a lot of losses, but what if the total amount of losses exceeds the amount in your trading account?
As you are trading in the Forex market, you will know that losing trades is inevitable, so in order to be able to sustain your account in the long run, you should have a risk of about 1% of your account for every trade. This way, you would not be putting your account at a huge risk in the event that you lose a trade.
Since the amount of risk per trade is reduced, therefore the drawdown would be reduced as well.
Establishing a cap for drawdowns
Establishing a cap is arguably one of the most difficult measures to reduce drawdowns. To help you better understand what it does, we’ll discuss an example.
Let us assume that you are risking 1% of your account for every trade and set a drawdown cap of 8% for every month. With this, if you lose more than 8% of your account every month, you cannot trade until the next month.
While it sounds rather harsh, it is an effective way of mitigating drawdowns. If you wish, you are also able to adjust the cap to your preference, such as using a cap every week instead of every month.
Take a break
When experiencing drawdowns, most traders would be anxious to keep trading in order to recover their losses. However, the market would continue to resist as you push harder to win.
Here, you can take a short break, recompose your emotions before coming back to trading. You should be able to work your way in recovering your losses more easily.
Considering other factors
Some factors that play a part in drawdowns in Forex include the Profit Factor, as well as the Recovery Factor.
The Profit Factor is used to determine how much money is earned for every dollar that is lost. The formula used here is Gross Profit over Gross Loss, so if your Profit Factor is below 1, you would be losing money, whereas if your Profit Factor is above 1, you would be earning money. Our aim is to hit a Profit Factor of 1.6 to create a buffer in the event that we are losing trades.
The Recovery Factor refers to the ability of the trader in recovering the amount of loss. The formula used here is Net Profit over Maximum Drawdown in absolute terms. You would need to derive the Recovery Factor by yourself. We would generally aim for a Recovery Factor of 2.0.
What is a good Drawdown percentage in Forex?
Every trader has a different opinion regarding what is a good drawdown percentage, since different people have different comfort levels when trading. For the majority of Forex traders, this number lies below 20%.
While it is important to aim for a low drawdown, you would also have to consider your overall profits and evaluate if it is worth risking more or if you should reduce your risks.
What is Risk Management?
In order to profit from trading in the Forex market, you would need to understand how to manage risks to prevent potential losses. This is what we know as Risk Management.
While it is usually overlooked by traders who are anxious to get their trades done, Risk Management is crucial as it can protect you against potential losses, but more importantly, it can help make your trades profitable and sustainable down the road.
What is a Risk-Reward Ratio?
The Risk-Reward Ratio is a technique for you to calculate the potential profits to the potential loss of a trade. The risk here is obtained with a stop-loss, with it being calculated as the entry point subtracting the stop-loss. The reward here is obtained by subtracting the profit target with the entry point.
The Risk-Reward Ratio can help you determine if the potential reward is able to outweigh the potential ratio or otherwise. With this, you are able to decide if it is a good idea to enter this trade.