Drawdowns in Forex is an important metric to help you understand the health of your trading portfolio and allows you to make trading decisions to prevent your losses from growing. This guide looks at what a loss is and how it can be useful for traders.
One of the key rules to successful Forex trading is controlling your drawdown, that is, managing the reduction in your trading capital incurred before losses cut into profits. Successful Forex trading is more than buying and selling currencies for profit, but also protecting your capital by minimising losses or drawdowns.
Managing your drawdown is one factor that separates experienced or successful traders from inexperienced traders. Experienced traders generally place high value in managing their risks when trading so diligently monitor the health of their trading positions and portfolio. Drawdowns help you understand the survivability of your trading strategies over the long run and allows to take proactively your positions before your drawdown size become untenable.
To transition from a losing trader to a successful forex trader you need to understand how to control your drawdown. This trading guide will explore what is drawdown in forex along with other key trading concepts like:
In forex trading, drawdown (DD) refers to how much money you have lost in your account balance or from a particular trade. It refers to the difference between the peak or high point in your trading account balance and the next trough or low point in the balance of your accounts.
A drawdown can be applied to a single position. In this case, your drawdown will be when the price buy-sell price falls below your entry price or to measure the health your whole portfolio. To do this you combine the winning and losing positions to determine at what point your portfolio balance hit its lowest point.
To understand how drawdown works, let’s consider the following example:
Note* In this case, the maximum drawdown is also 10% since it’s equal to the maximum peak to trough decline.
Most often, the drawdown is expressed as a percentage, but it can also be recorded in dollar terms.
If we consider the same trading example, the drawdown expressed in dollar terms was USD 1,000 because that’s how much the account equity dropped following the losing streak.
Drawdown can be expressed in absolute terms, relative terms and maximum terms. A top-down approach to analyzing the past performance of a trading strategy involves evaluating the absolute drawdown, relative drawdown and maximum drawdown together.
The different types of drawdown can help us measure the potential loss of capital incurred if we used that particular trading system.
Relative drawdown is your unrealized loss. Drawdowns are temporary as long as you hold onto your position and only become realised once your stop loss is triggered or you close your position.
For example, the sums of all open positions that are right now are losing money constitute the floating drawdown. A floating drawdown is the farthest distance against your position that the price has moved while the forex trade was active.
However, as soon as the losing trades are closed, that drawdown becomes a fixed drawdown. The absolute DD and max DD are fixed drawdowns.
The maximum drawdown is the maximum peak to trough decline in your account balance.
In other words, the maximum drawdown measures the distance between the highest account equity value and the lowest account equity value over the entire trading account lifespan.
The absolute drawdown shows how big the loss is relative to the initial deposit.
To understand how absolute drawdown works, let’s consider the following example:
Only when the account value drops below the initial deposit we can talk about the absolute drawdown. We take the difference between the initial deposit and the account equity trough below that level. So, if the account balance drops below the initial deposit of USD 10,000 and it’s now valued at USD 7,000, we’re talking about an absolute drawdown of USD 3,000 (the difference between the initial deposit and the next equity trough).
In forex trading, the drawdown is calculated as a percentage of your account balance.
The maximum drawdown formula is the ratio of the all-time equity high and the difference between the all-time equity high and the all-time equity low.
Let’s walk through a practical example.
With some luck and a good trading plan, trader Joe has managed to bring his account balance to a new peak of USD 20,000. However, before he turned things around, his account balance hit a low point of USD 9,000.
Taking into account the values from the example above the max drawdown incurred by trader Joe is 55%.
It’s important to measure drawdown because it’s a metric that helps forex traders assess the account balance volatility. In other words, it will tell you how much and how far your account equity will drop after a losing streak.
Drawdown is also a good metric to evaluate the performance of a trading system. For example, a trading strategy with a large drawdown indicates a high-risk and high-volatile trading system. By measuring forex drawdown, retail traders can better evaluate if that trading system fits their risk tolerance and investment goals.
As a general rule, the bigger the forex drawdown is, the bigger the up and down swings in your account balance is going to be.
When measuring drawdown, another key characteristic is the time it takes to recover from the drop in your account balance. For example, if your account balance is experiencing a large drawdown of 50% due to a series of consecutive bad trades, to get back to breakeven you’ll need to make 100%.
The main thing is that recovering from a large drawdown requires more effort.
Let’s continue with our initial example and see how much, trader Joe would need to gain in order to just recover the 10% max drawdown. Beginner traders mistakenly believe that if you lost 10% you need to make 10% to be at breakeven (BE). Unfortunately, that’s not how things work in forex trading.
The table below highlights the relationship between drawdown and how much you need to make back to recover from different levels of drawdowns.
The lesson to learn here is that you need to control the drawdown, because the larger the drawdown is, the harder it will be to recover from it. The amount of money that you need to make to get back to breakeven will always be larger than your DD.
Drawdowns are an inevitable part of trading as they are more common than you might think. In this regard, it’s normal for our trading accounts to also incur a drawdown. If we can’t run away from a drawdown, then we need to learn how to keep the drawdown under control. This is where proper money management strategies allow forex traders to recover from large drawdown and continue moving forward.
Coping with drawdown can be mentally challenging. So, before you look at ways to keep a drawdown in forex under control, the first thing you must do is to understand why drawdowns happen.
There are several reasons behind the forex drawdown but, the most common causes can be summarized as follow:
No matter how long is your trading career, you’ll still experience drawdowns. They say you can’t teach an old dog new tricks but in the forex space the learning curve never actually stops. So, no matter if you’re just a novice trader or a more experienced trader, you can still learn new trading tricks on how to bounce back from a losing streak and better control the drawdown.
Obviously, the most important thing is to avoid large drawdowns. Large drawdowns are one of the worst things that can happen to you as they can be difficult to recover from and no one likes losing money.
Without further ado, see below the trader’s guide to dealing with drawdowns (7 drawdown trading strategies):
The 2% rule refers to you keeping your risk low and only use 2% of your capital on any given forex trade.
For example, if two traders start with $10,000 in their trading account and both of them suffer a losing streak of 5 bad trades, but one of them only risks 2% per trade and the second traders take on a higher level of risk (5%). In this case, the first trader has suffered a drawdown of 9.6% and at the same time, the second trader suffered more than double the drawdown (22.6%).
Obviously, the first trader would need a smaller percentage gain (11%) to get back his loss as compared to the second trader who would need approximately 30% gains to breakeven.
The second rule for a long-term trading career is to learn to deal with the psychological turmoil that comes with drawdown. The first step is to take responsibility for your own trading decisions. Therefore, you need to hold yourself accountable for the forex trades you take and determine a course of action to repair your mistakes
Large drawdowns don’t happen overnight but, they all start with a smaller drop in your account equity curve. Suffering a drawdown can be an emotional rollercoaster for many traders when real money is on the line. This is an added level of stress that usually leads to more trading mistakes and subsequently bigger drawdowns.
Knowing how to control your emotions while you suffer a drawdown can limit the losses you take moving forward. A very powerful technique to be emotionally detached from your losses is to step back for 1-2 weeks, clear your mind and come later with a fresh mind. While this might seem redundant, taking trading breaks allows us to regain control over our emotions, trading strategy and our trading plan.
According to the Myopic loss aversion theory, the more frequent you see information about the drawdown, the more likely you’re to want to rein in the risk. So, if you don’t check your PnL too frequently, you’re more likely to be emotionally detached from your losses.
The best way to reduce drawdown in forex is to limit your trading activity to only one trade at a time. If you only take one trade at a time and keep the level of risk at 2% per trade, in the worst-case scenario you’ll only lose 2%. If you know your favourite currency pair (EUR/USD, GBP/USD, etc.) you can stick to trade only that FX pair.
Beyond the traditional stop-loss, traders should consider also using an account equity stop loss. The account equity stop works the same as the standard stop-loss order but once this stop is triggered all open positions will be automatically closed at the market price.
For example, if your account balance is USD 10,000 and you set an equity stop loss at USD 7,000, it means that when the sums of all open position equal USD -3,000, your forex broker will automatically liquidate the floating PnL. In other words, you have limited the forex drawdown to 30%.
This is a good stop loss method to be implemented as soon as you fund your trading account. Check out with your forex broker if it supports equity stop loss.
The maximum drawdown that you’re willing to accept is mainly going to be in accordance with your risk tolerance. However, you don’t want to have a larger drawdown than 30% because you’ll need more than 43% returns to recover from that loss.
Rank your trade setup based on profitability and keep the level of risk lower on the low probability trades. If you have fewer favourite price action patterns and still believe it’s worth giving it a try you can do 2 things:
Setting a maximum daily loss limit is the practice of capping the losses on a single day to a certain level. When the daily loss threshold is reached, you need to stop trading for the rest of the day and only start resuming trading the following day. As a rule of thumb, experienced traders use a 5% – 6% daily loss limit.
If you’re in a situation where your daily loss limit is hit too frequently, that’s not a sign for you to extend your daily loss limit. A more appropriate response would be to either lower your position size per trade or in extreme cases you’ll need to go back to a demo account and figure out what’s wrong with your trading strategy.
Even the more experienced forex traders and the big hedge funds go back to the drawing board when they perform poorly.
If you’re actively trading forex and CFDs, you really need to employ a daily loss limit system to protect yourself against bad trades. This practice will reduce the volatility of your account equity.
Another way to reduce drawdown is to use what is called a guaranteed stop-loss order (GSLO). The GSL order safeguards your trade by ensuring that your stop loss is executed at the desired price without any slippage.
For example, if you trade EUR/USD and have the stop loss set at 1.1750 no matter the market volatility, your stop loss will always be triggered at 1.1750.
Usually, the guaranteed stop loss is available only with certain forex brokers and only works on a selected few instruments in exchange for a small fee.
See the full list of forex brokers with guaranteed stop-loss orders.
If you want to be a successful forex trader that’s going to make money over the long-term and don’t burn out your account quickly then you need to keep drawdown under control. Drawdowns are part of trading and once in a while, everyone is going to have to deal with them. Try incorporating into your trading plan some of the techniques taught throughout this drawdown trading guide if you really want to cope better with drawdowns.
Risk Disclaimer: Leverage trading can amplify drawdowns exponentially. So, make sure you don’t overlook the importance of risk management strategy in your trading.
Justin Grossbard has been investing for the past 20 years and writing for the past 10. He co-founded Compare Forex Brokers in 2014 after working with the foreign exchange trading industry for several years. He also founded a number of FinTech and digital startups including Innovate Online and SMS Comparison. Justin holds a Masters Degree and an Honours in Commerce from Monash University. He and his wife Paula live in Melbourne, Australia with his son and Siberian cat. In his spare time, he watches Australian Rules Football and invests on global markets.