Capital management is always a matter of concern while making investment in any market. Even for seasoned and experienced traders, Stop Outs or Margin Calls still frequently occur. In addition to an effective strategy, reasonable capital allocation, investors also need to know how to control the account or what this figure is.
Too much focus on the profit ratio will make the Drawdown larger and more difficult to control. In this article, FXCE will redefine what Drawdown is to show its importance when trading. At the same time, classify and suggest some tips for investors to keep it in control.
Drawdown can mean various things in finance. For instance, in banking, it refers to using credit or savings. In forex especially, Drawdown refers to a decline of equity in your portfolio. Each forex trading strategy you employ will eventually experience it at some point. In the Forex market, a Drawdown occurs any time your total capital decreases.
Drawdown is a peak-to-trough fall for an investment, trading account, or fund over a defined time period. The percentage difference between the peak and the following trough is typically used to describe a Drawdown.
Based on the definition, we can have the formula:
|Drawdown (%) = (peak - trough) / peak|
Types of Drawdown
1. Absolute Drawdown
Absolute Drawdown uses your initial capital as a reference point which means your initial deposit minus your minimal equity. If Absolute Drawdown is 0, then you have no loss or have not started trading yet.
Say you deposit $10,000. Then, your portfolio goes down to $8,000—this would be called your “minimal equity,” as it refers to the lowest point your portfolio goes. In this example, that would be that your Absolute Drawdown is thus $2,000.
2. Maximum Drawdown
Maximum Drawdown (MDD) uses your equity peak instead of your initial deposit to calculate your loss. Using the same example as above, your equity peak is $12,000, and your minimal equity is $8,000. Your MDD is your maximum peak minus your minimal equity. In this case, your MDD would be $4,000.
Maximum Drawdown shows your loss compared to how much cash you could have had, not how much cash you actually had. One of the ways to limit Maximum Drawdown is to calculate Stop Loss and Take Profit accurately and can be changed as needed.
3. Relative Drawdown
The Maximum Drawdown percentage is the simplest explanation for Relative Drawdown. Often, you’ll see a Drawdown presented as a percentage of your portfolio. In the above example, your MDD is $4,000, and your maximum peak is $12,000. Divide 4,000/12,000, then, multiply by 100 . This shows that your drawdown cost is at 33.3%.
Looking at the Relative Drawdown will be easier to visualize the risk of the account through a percentage of loss than looking at a specific number because the capital of each position is different. When it comes to what Drawdown is, Relative and Maximum are also more commonly used than Absolute.
4. Daily Drawdown
This is basically a Relative Drawdown, but it is calculated over a period of 1 day. Scalping or IntraDay traders can use the Daily Drawdown to keep a close eye on unsatisfactory orders that must be extended.
Drawdown Index Used on FXCE Social Trading Platform
Balance Drawdown: Based on the original account, the drawdown is calculated and demonstrates the trader's broadest level of control.
Equity Drawdown: Based on the overall Balance and Floating Profit/Loss (profit/loss), the drawdown is determined. The ability to more closely manage risk is demonstrated by equity level.
Floating Drawdown: (it is basically Absolute Drawdown) Different from Balance drawdown and Equity Drawdown, Floating Drawdown does not calculate the floating profit.
>> Equity Drawdown is one of criterias to approve Trader’s Guard at FXCE. Learn more about the benefits of our social trading platform: Benefits of Joining FXCE Giga EA Community
Ideal Drawdown Level
Theoretically, make sure that the ideal Drawdown is 0 or as low as possible. However, in investment, especially in volatile markets like Forex, it is impossible that the account will be permanently positive, so all traders can still accept a certain Drawdown level.
However, if the Drawdown ratio is too large, it shows that the trader is investing inefficiently and is not safe in the long term.
Typically, financial analysts will take the 20% mark to assess the risk level of an account. Depending on the actual situation, the investors themselves recalibrate this number according to their needs.
The selection of a reasonable Drawdown number is partly influenced by the recovery time of the account, the breakeven of a losing order. As can be seen, the larger the Drawdown, the lower the probability of breaking even, so the less experience the trader has, the more reasonable the number of Drawdown traders will be.
Drawdown - Loss of Trading Capital
% Gain to Recover Loss
Tips to Control Forex Drawdown
1. Emotional Control
Do not make trading decisions based on emotion, we must stress this. It can be difficult when you’re experiencing losses. Who wouldn’t want to tear their hair out when their portfolio dips over 20%? Yet, feeling angry or afraid will only cause you to make hazardous, ill-informed trades.
Take a deep breath. Don’t make any trades until you can genuinely care about all those squiggly lines on the screen and make it through a full article about how the stimulus will affect the dollar, or why Swiss traders have started investing more. Once you’ve got your head screwed on straight, you can start trading again.
2. Lower The Risk
Depending on the following factors, each person can consider the acceptable Drawdown level for the account:
Capital size; demo or cent account
Order holding time
Usually, the higher the capital, the lower the Drawdown limit should be or the holding time of the day can be higher for 1 week.
When Drawdown number is exceeded, you should build or adjust the trading system. If the rate has not improved, investors need to review the strategy. Once stabilized, traders can manually set a penalty each time the Drawdown exceeds the limit.
3. Divide the capital into little orders
You can also apply a loss limit for each order of only 1-1.5% of the total account capital. Thus, if you lose 5 orders in a row, you only stop Drawdown at 5-7.5% instead of putting all into one order. To apply this type of trading, you need to strictly follow Stop Loss, use a moderate leverage ratio and appropriate trading volume.
4. Learn more about capital management
Every trade you make carries some level of risk, but as long as you can quantify that risk, you can manage it. Please keep in mind that risk might be increased by applying excessive leverage relative to your trading capital as well as by a lack of market liquidity. The only way to achieve good returns on trading is to take some risk with a disciplined approach and good trading habits.
If you experience a Drawdown in forex, don’t be down—it happens even to the best traders. Just make sure you keep a level head and make positive trading decisions that can keep you from crashing and burning.