What is a Drawdown in Forex Trading?

Contents

• What is a Forex Drawdown?
• Types of Trading Drawdowns
• Why is Drawdown Important for Traders
• What is a Normal Drawdown?
• How to Reduce Drawdown

What is a Drawdown in Forex?

In forex trading, there are stages of growth in the account balance as well as reductions in available funds for investment. When there are so many losing trades that it becomes noticeable on the trading account and in the statistics, this is called a drawdown.

It should be said that this is a completely normal phenomenon that traders should not fear or try to avoid. Trading involves risk, including the risk of losing money entirely. A moderate loss of 15-20%, if controlled and aligned with the strategy, is acceptable and considered a common occurrence.

Types of Drawdowns in Forex

On the foreign exchange market, the following types of drawdowns are classified:

• Current Drawdown. Current drawdown in forex is a temporary, working drawdown that arises from open trades currently in the red. In this case, the initial deposit amount does not change, but the amount of funds (equity) will fluctuate depending on the market direction. No one knows how this drawdown will close – with a profit or loss, it may even disappear if the market reverses, so it starts to be taken into account when the loss is very significant. In this case, it is necessary to think about the Money Management rules of your strategy.

• Fixed Drawdown. Fixed drawdown is a closed trade that was in a losing position at the time the decision to close the position was made. Fixed or, as it is also called, actual drawdown negatively affects the deposit size, reducing it by the percentage obtained as a result of closing the trade.

• Maximum Drawdown. Maximum drawdown shows the level of maximum losses of the deposit as a result of closing losing trades over the entire trading period. Its calculation is done each time from the previous maximum deposit size, and the largest value is selected. For example, there were three large losses on the account: $300 with a deposit of $1000, $450 with a deposit of $2000, and $200 with a deposit of $2500. The maximum here would be a drawdown of $450.

• Relative Drawdown. Relative drawdown shows the maximum decrease in funds relative to the initial deposit, expressed in percentages. This indicator is often considered in the analysis of trading strategy, as it shows what losses a trader using it should take into account. For example, if the relative drawdown is 20%, then with an initial deposit of $1000, a speculator will understand that they need to close trades and modify their tactics when the current drawdown reaches $200.

• Absolute Drawdown shows by how much the balance has decreased relative to the initial value. These data are similar to the relative drawdown, but expressed in the currency of the deposit.

Why Analyze Drawdown?

Drawdown is an important component of trading strategy. The percentage of drawdown built into it shows how risky actions traders or managers are ready to take.

Investment companies managing client funds typically agree on an average drawdown of 15-20%. Private traders trading with their own funds can increase this percentage and accordingly, financial risks.

Optimal Drawdown Size

In reality, it is difficult to say what size of drawdown is considered optimal. Many different factors are taken into account: type of trading strategy, trading deposit, trader’s psychology, time frame, asset volatility, and others. However, three approximate criteria are generally identified:

• Drawdown of 15-20% – workable and quite normal. It is possible to recover from it, and it does not significantly affect the trading strategy.
• Drawdown of 21-35% – a dangerous loss level that will require reducing the trade volume and recovery may be difficult. Closer to the 30% mark, it is important to consider modifying the trading strategy and reviewing it for errors in the risk management system.
• Drawdown of 36-55% – an actual precursor to deposit loss. Orders are better to close and think about what led to such a drawdown that was not forcibly closed earlier.

How to Reduce Drawdown in Forex?

The main actions to minimize drawdowns are:

• Setting a stop-loss – and its size should not exceed 5% of the total amount on the trader’s account. The order is placed simultaneously with the opening of a new position, but never later.
• Optimal leverage – using a large leverage can lead not only to drawdowns but also to the trader’s deposit being wiped out almost to zero.
• Refraining from trading on an unstable market – very often traders, even following the first two conditions, still manage to lose almost half of their own funds during one session. Therefore, if you have made several unsuccessful trades in a row, it is better to refrain from trading for the day and do something else.
• Proper assessment of potential profit – do not be greedy when setting a take-profit, its size should always correspond to the market dynamics.

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FAQ

What is a drawdown in trading?

A drawdown is a temporary reduction in account balance due to losing trades.

How to calculate drawdown?

Drawdown is calculated as the difference between the highest account balance and the lowest subsequent balance during a trading period.

What is a normal drawdown?