A reality that every Forex trader must face in their trading is drawdown. No matter what trading system or trading strategy you follow, drawdown is an inevitable part of every trader’s journey. What makes a successful Forex trader different from someone who fails is how they manage drawdown.
As much as we may wish we never took bad trades, bad trades are a reality of the business. You will experience a losing streak every now and then, and that will reduce your equity curve.
In this article, we’ll talk about what drawdown is, how to calculate it, what kinds of drawdown there are, and strategies to avoid and recover from drawdowns.
What is Drawdown?
Drawdown is a term that has many different meanings depending on the context. Basically, it’s a drop from a peak to a trough in an investment, a fund, or any amount(Investopedia).
In Forex trading, drawdown is the difference between your initial account balance or equity peak and your equity trough.
You don’t have to use the highest peak and deepest trough, either. You will choose peaks and troughs depending on the timeframe you wish to calculate drawdown for.
Obviously, the peak has to be before the trough, otherwise you would not be able to calculate it!
How to calculate drawdown
The easiest way for calculating drawdown is to measure a peak to trough decline.
Let’s look at Mac, a Forex trader.
He has an initial capital of $20,000. Due to market volatility and some losing trades, his account balance is now $18,000.
Mac’s account is in a drawdown of $2,000, or 10% of his initial capital.
Types of drawdown in Forex
In Forex, drawdown refers to a few different things. Each data point will tell you a different story about the health of your trading account, so it’s important to be able to calculate each one and know what it means.
Note: Knowing the difference between the types of drawdowns is critical if you’re planning on attempting a prop firm challenge. Many prop firms base their rules on absolute drawdown, while others base their rules on maximum drawdown.
Knowing the difference between these two can prevent you from failing a challenge, or worse, losing a funded account!
Absolute drawdown refers to the difference between your initial account balance and a low point or trough in your equity curve.
Going back to our trader friend Mac, let’s say he had an initial deposit of $20,000 and a few losing traders put him $3,000 in the red.
This means Mac is in an absolute drawdown of $3,000 or 15% of his initial account equity.
To calculate absolute drawdown, you’ll use the initial account balance minus the lowest trough in the quity curve.
Maximum drawdown refers to the difference between the maximum peak in your equity curve and the lowest trough after that.
Suppose our friend Mac had a few winners and his account has grown from his $20,000 deposit to $25,000.
He experiences some more losses and his balance is now back to $20,000.
This puts his maximum drawdown at $25,000 – $20,000 or $5,000.
In percentage terms, that’s a whopping 20% drawdown from his maximum capital of $25,000!
This should help highlight the difference between maximum and absolute drawdown. In the example above, the maximum drawdown is $5,000, but the absolute drawdown is $0 since Mac is back to his original account balance.
Many prop firms use the highest point of unrealized equity as part of their maximum drawdown formula.
Here’s an example to help make sense of that:
Mac is trading with a prop firm and has an initial balance of $20,000. He has a maximum drawdown limit of $2,000 or 10%.
Mac places a trade that goes $2,000 into profit before closing it out for $1,500 in profit.
Even though his account balance is $21,500, he’s already $500 in drawdown from his maximum equity peak of $22,000.
The last type of drawdown is relative drawdown. Relative drawdown can be thought of as unrealized drawdown.
Mac has a few open positions out of which some are in profit and others are in loss.
The net value of his open positions is -$1,000, so his relative drawdown is $1,000.
If he closes all of positions right now, that relative drawdown will become realized drawdown.
What happens when you go into drawdown?
Drawdown is a part of Forex trading. Small drawdowns are routing and can occur when you run into a losing streak.
However, the more you go into drawdown, the harder it is to recover from it.
The table below illustrates how much you need to gain from each level of drawdown to get back to your initial account balance.
|Drawdown percentage||Percentage gain required to recover|
If you experience consistent drawdowns, it may be a sign that you need to re-evaluate your trading strategy or risk management rules. It could also mean you’re not getting in the market at the right time.
The most important thing to remember about going into drawdown is to not lose your cool.
Many traders, especially beginners tend to take on more risk the further they go into drawdown. This is a recipe for disaster, because with every losing trade, you’re digging an exponentially bigger hole for yourself.
Let’s say Mac goes into a drawdown of $2,000 from his original account of $20,000.
He usually risked 2% per trade and 5 losers put him in this spot.
He decides to double his risk to try to make the money back quicker.
That trade is also a loser, and he’s now down 14% from his original balance.
Experienced traders know to have a drawdown cap and never put yourself into a situation where you can go into a large drawdown.
How to recover from drawdown (or avoid it altogether)
1. Manage your risk by using a stop loss
One of the easiest ways that forex traders sink into drawdown is because they don’t use a stop loss, their stop loss is too wide, or worse, they move their stop loss hoping the trade will turn in their favor.
The most important way to protect yourself from excessive drawdown is to protect each trade with a stop loss and practice sensible risk management. You must decide what percentage you’re willing to risk on every trade(your risk tolerance), and then stick to that.
A stop loss is the first step, but it has to be coupled with a good strategy and good risk management.
You can’t take 10-15 blind trades a day, “use a stop loss”, and still expect to be profitable.
Stop losses are there to protect you from excessive drawdown, but you still need to take good entries that have a high probability of going your way.
2. Control your emotions
The next step is to keep your emotions in check. When there is real money to be lost or made, your emotions can get the better of you.
It’s especially tempting after a losing trade or a losing streak to start revenge trading. That’s when you take “revenge” on the market to get back the money you lost.
This is a HUGE red flag and a revenge trade is almost always a bad trade. That’s because you’re no longer trading based on rules and logic, but instead, you’re trading on emotion.
It’s almost a guaranteed way to lose money.
Trading Forex is tough, but you need to stick to your trading plan and risk management rules no matter how much your drawdown goes.
3. Decrease risk on positions
If you find yourself having lost on a few Forex trades, one of the best risk management strategies is to decrease your overall risk per trade.
If you typically risk 2% per trade but you’ve lost a few trades in a row, curb your risk to 1% or 0.5% until you have a few more winners under your belt and you regain confidence.
The trades you take with less risk will also be much less stressful.
4. Don’t take multiple trades at a time
Many Forex traders sink into too much drawdown at once because they have multiple trades open at any given time.
So even if you risk just 1% per trade, if you have 5 open trades and all of them get stopped out, you’re down 5% in a single day.
Profitable traders know to concentrate on just one or two targeted trades per day according to their trading plan.
The only time you can or should take multiple trades at once is if you have an open trade that is either risk-free or in profit.
5. Close partial trades and move stops to break-even
Forex is one of the most volatile markets in the world, and it’s not uncommon for a currency pair to move hundreds of points in a day.
I’m looking at you, Gold!
There will be many instances where you’ll start a trade in profit only for the trade to turn on you and end up as a loss.
To avoid this, set multiple targets for your trades and close out parts of your position as each target is approached.
Let’s say you enter a long trade in the EUR/USD at 1.1300.
Once price reaches 1.1320, your first target, you close half your position and move your stops to break-even.
This way, you’ve secured some profits and eliminated all risk, and you can let your trade run as long as it goes.
6. Reassess your trading strategy
Market conditions are always changing and a trading strategy that used to work can stop working for whatever reason.
If you experience a lot of drawdown and a large string of losses, you may need to go back to a demo account and reasses your strategy to make any necessary tweaks before you start trading again.
Re-evaluation your strategy can help preserve your remaining capital and better protect you from future drawdowns.
7. Take a break and step away from the charts
Finally, the most extreme, but sometimes the best option is to just stop trading and take a break from the charts. Even the best Forex traders understand that there will be some days where you should just walk away from the charts, cease all trading activity, and focus on doing something else.
In fact, some Forex traders(myself included) have a rule where they’ll walk away if they experience two losses in a row on any given day.
You should practice some form of this: it helps to clear your head and you can return to the charts the next day with better focus.
Drawdown in Forex is something that’s going to happen to every trading account, no matter how good the trading system is. That’s just the nature of the Forex market. Anyone who says otherwise is not a real trader.
What differentiates good traders from bad traders is how they handle the drawdown. Some capital loss does not have to lead to more capital loss!