What is forex drawdown? What is the best drawdown rate?
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Big profits always come with high risks. Therefore, besides profit, traders need to pay attention to risk control and capital management. An important criterion to measure that level of risk is drawdown. So what is a forex drawdown? What is the best drawdown rate?
What is forex drawdown?
Forex drawdown decreases an investment account from its peak to its trough in a certain period. Drawdown is usually stated as a percentage of the previous capital.
The formula for calculating drawdown = the amount of capital that fell the most in the period ( = capital bottom – capital peak) / the amount of money invested at the height of the period.
Drawdown example:
Trader deposits to forex account 10,000 USD. After trading, the trader grows this capital to 16,000 USD, then loses again to 8,000 USD. Finally, the trader ended the year at $12,000 in the capital. Thus, the trader’s maximum capital is 16,000, and the lowest capital is 8,000. So the amount of money reduced in the trader’s account is 16,000 – 8,000 = $8,000. The drawdown ratio is 8,000 / 16,000 = 50%.
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How is the forex drawdown important?
Transactions always have a drawdown (referred to as DD). Nobody doesn’t have a drawdown. Since loss is always a part of investing, traders must keep it under control. The drawdown is as low as possible.
A trading system that has backtested in the past and produced good returns is not everything. Traders need to pay attention to the drawdown rate. If the drawdown is too large, the risk is high.
In forex trading, tracking drawdown indicators helps manage capital and manage risks effectively. If the account has a low drawdown ratio, the trading system works well and is stable in the long term. At that time, the trader needs to maintain the profit rate for each trade. Conversely, a high drawdown ratio indicates a high-risk trading strategy. At this point, traders need to adjust their trading strategies to limit the decline and preserve capital.
Besides, the drawdown rate is also one of the essential criteria when choosing automatic trading robots or copy trading accounts.
Suppose a trader wants to buy or use an automated trading robot, a forex signal, in addition to the profit margin, the drawdown is a criterion not to be missed. An EA has an average return of 30% per month, but a Relative Drawdown is up to 65%. This EA has a relatively high level of risk, and traders should not choose.
Similarly, when choosing a copy trading account, in addition to considering the profit, the trader must also check the drawdown rate.
What are the types of drawdowns in forex?
Drawdown is the capital loss in a particular investment period, but drawdown has three different calculation methods. Moreover, each type of drawdown represents a distinct sense of risk of the trading account.
Drawdown is of three types: Absolute Drawdown, Maximal Drawdown, and Relative Drawdown.
Absolute Drawdown: This is the decrease in the account from the initial capital to the lowest bottom. This indicator is measured by the total loss (USD). The Absolute Drawdown value changes when the account balance making the bottom is lower than the previous low. This indicator represents the highest amount of capital loss from depositing the account to the present time. The higher the Absolute Drawdown, the more it shows that the trader is losing more than the initial capital.
Maximum drawdown is the decrease of the account from the highest capital peak of the performance to the lowest capital bottom. Maximum drawdown represents the account’s highest loss result during the whole trading process, showing a higher risk level than Absolute Drawdown.
Relative drawdown is the Maximum Drawdown calculated as a percentage. Relative drawdown = Maximum Drawdown / The highest peak of capital. Relative drawdown is a percentage, so it is easier for traders to know the risk level than looking at a specific number of Maximum Drawdown.
What is the best drawdown?
Among the drawdown indicators, Maximum Drawdown or Relative Drawdown is the most important one, which clearly shows the maximum drawdown of an account and its riskiness. So how much Maximum Drawdown is best?
The most correct answer is: The lower the Maximum Drawdown the better, the less risk.
However, forex trading is not always profitable, losses are certain to happen. Therefore, even as a professional trader, their Maximum Drawdown should still be a ratio greater than 0%.
There is no standard ratio to determine the account with good drawdown. But usually, experts take the 20% mark to assess how risky an account is. This means that your trading system must ensure that the Maximum Drawdown does not exceed 20%.
Assuming you lose 20% then you need to achieve 25% profit on the remaining capital to get back to the original capital. If you lose 50% then need to win 100% on the remaining capital to return to the original capital and if you lose up to 80% then the required win rate to return to the original capital will now be 400%. The higher the Maximum Drawdown, the harder it is to break even.
How to control the drawdown?
In forex trading, trading psychology is an essential factor. It can disrupt any trader’s trading plan. Therefore, to achieve a low drawdown rate, traders must control their trading psychology well.
Limit one maximum drawdown for the account.
The maximum drawdown limit is not more than 20%. Some people choose the rate of 20%, but others choose 15%. Moreover, traders need to set limits for a specific time period. For example 1 week, 1 month or 1 quarter…
A trader makes a maximum rule drawdown no higher than 20% for a month. If this ratio exceeds 20%, the trader is no longer trading. After that, traders need to review their trading system or capital management strategies and start with a new system in the next month.
Lowest loss limit per trade.
One of the rules traders can apply to limit the loss of each order to only 1-1.5% of the total available capital of the account. With this principle, if the trader loses ten consecutive orders, the account will only lose 10-15%. If losing 20 orders in a row, the account loses 20-30%, the ability to recover to breakeven is possible.
To apply this principle, traders need to adhere to an average leverage ratio, combine low trading volume, and set stop loss on all orders.
Besides, if the trader continuously loses, the trader should reduce the loss limit, corresponding to the current capital. Suppose that the trader initially limits the loss of each order to 2%, then loses 10 consecutive orders, the account loses 20% of the capital. At this point, the trader should reduce the loss rate to 1.5% or 1%, this strategy will help the drawdown rate not increase too quickly.
However, if the number of consecutive losing orders is more than 30% or the drawdown has exceeded the allowable limit, the trader should stop.
Conclusion
Drawdown is very important in capital management, risk management. For traders to be profitable in the long run, it is necessary to have a good trading strategy and effective risk management. Keeping track of trader accounts’ drawdown rate is easy, but how do traders keep it under control? There are countless techniques, but the rule for traders to manage capital most effectively is discipline.
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