In the world of financial trading risks and rewards are highly correlated. Higher the risks, the higher the potential rewards. The main goal of professional traders is not to take huge risks and double their money overnight, the main goal is to develop optimal trading systems that will enable them to grow trading capital gradually and therefore increase their income. Investors value traders with small drawdowns the most. There’s no trading system, indicator or a strategy that doesn’t experience drawdown periods. Let’s learn what drawdown is and what to do when they occur.
Drawdown definition
In Forex, when we talk about drawdowns, we generally mean periods of declining account trading balance. Drawdowns are a decline in funds from the highest point to the next low point.
Drawdowns are calculated in percentage points for a given period of time. For example: if our initial investment was 10,000 USD, the balance fell to 8,000 and later increased to 10,100, our drawdown was 20% from the initial investment.
Why is Drawdown important for traders?
- Understanding drawdowns in trading can help traders find investors. Investors value traders that have small drawdowns and reliable results.
- Drawdowns are natural in trading. The key to success is in learning about what they are and how to minimize their impact when they occur.
- Analyzing drawdowns can help traders develop better trading strategies.
Thorough Drawdown explanation
Account Drawdowns are inevitable. Every trader experiences periods of decline in trading balance. However, managing the drawdowns and limiting their impact is essential as drawdowns can tell investors how risky it is to entrust their funds to you. Drawdowns are calculated for certain periods, they measure the amount of money that was lost in percentage points. Drawdoins are calculated from balance picks to following balance lows.
When drawdown periods are underway, many traders set limits to themselves, for example, they might reduce their risk exposure by making their trading positions smaller. Some traders even stop trading for a period of time if their account drawdown nears a predetermined percentage point. For example, if a trader experiences a 10% drawdown, his trading rules might tell him to stop trading for 2 weeks, analyze what went wrong, and start trading using smaller positions for as long as it takes to build back confidence.
Example of Drawdown in Forex
Now, let’s see a drawdown example in Forex. Let’s say that we have invested $10,000. After a month of trading our balance peaked at $11,000. Another month has passed and we experienced a drawdown. The lowest point the trading balance reached was $9,000. We have lost a thousand dollars from our initial investment, but the drawdown is calculated between the highest and lowest points. In this case, drawdown was $2,000 or 18% (from $11,000)
FAQs on Drawdown in trading
How is Forex Drawdown calculated?
Forex Drawdown is the difference between the peak and trough of your investment. So let’s say you have a $10,000 investment and then it fell down to $8,000 without exceeding initial investment. In this case the drawdown would be 20%.
Why are drawdowns important for investors?
Drawdowns are the first thing investors start analyzing when they are considering whether to fund you or not. Your drawdowns are the risks for your investors. If you are planning to stay in the trading business long term, managing drawdown periods is essential for success.