What Is Drawdown in Forex Trading?
Forex trading is all about converting currencies from one to another to make a profit. Similar to stocks and shares, forex trading is about understanding market forces to tell you when it’s a good time to invest your money.
Investing in forex will inevitably come with profits as well as losses. This article will explore drawdown: the difference between the winning and losing trades in your account.
What Is Drawdown?
Simply put, drawdown is about understanding how much money you may have lost as a result of forex trades. It takes the high point (either the amount of money that you start with or the amount of money that you’ve earnt in profit) and the low point of your account balance (perhaps you’ve lost money in a trade) and expresses the difference between them as a percentage.
The calculation is the difference between a relative high in your capital minus a relative low.
You may start at £10,000 in your account.
After a bad trade, the balance in your account may drop to £9,000.
This indicates a 10% drawdown – even if your capital balance rises again.
Why Is Drawdown Monitored by Forex Traders?
Forex trading is all about risk management. It’s about using your understanding of volatile markets to understand the best trading times and knowing how to minimise your losses.
This is where drawdown comes into play.
As we’ve just explained, the drawdown represents the amount of money you have lost as a percentage. Therefore, if you’re new to forex trading, you want this figure to be as low as possible.
Understanding drawdown ensures that you remain profitable for as long as possible.
Like the stock market, when it comes to forex trading there will always be a time when you hit a losing streak – no trading system can be profitable all the time. Knowing how to manage this losing streak will determine your overall profitability.
Your drawdown percentage helps you understand how much capital you have and how much longevity your system has. If you continue to experience drawdown as a result of a series of bad trades, your capital will quickly be reduced and you’ll be forced to cease trading.
If you hit a losing streak, you may be able to cope with several 5% to 10% drawdown losses in a row before you move into an upward swing. But, if you suffer from a 50% drawdown and experience a significant loss, you will have to achieve a 100% return to simply break even.
As you can see, that’s a much harder challenge and extremely difficult to achieve.
Forex traders monitor their drawdown because it allows them to change their systems and strategies to ensure that they can continue trading.
Some traders may aim for an 80% win-ratio – and whilst this sounds promising, there is no guarantee that winning 80 out of 100 trades will see you remain profitable. After all, that would indicate that you only lost 20 trades out of a hundred – but if you’re on a downwards slide and the 20 losses are consecutive, can you be sure you’ll still be in a position to continue trading?
This is why skilled forex traders will use their understanding of drawdown to minimise their risks. They’ll focus on the smaller trades so that, if they do hit a losing streak, they can survive the losses and continue trading.
How to Handle Drawdowns
Here are a few strategies for handling forex drawdown and minimising your risks:
1. Don’t Expect to Win Every Trade
You’ll never be able to win every single trade; it’s simply not possible. Instead, you need to decide how much loss you’re prepared to accept before you move on. Measure your success over a series of trades and not on each win or loss.
2. Use Your Stop Loss to Reduce Your Risks
If you’re using a dedicated forex signal provider, you’ll be able to use your automatic closing points (ACP) and set up your stop loss (SL) features. This is where your trade will automatically cease based on your pre-determined criteria.
Perhaps you’re only willing to accept a 5% drawdown; in which case, if the trade does start to fall negatively, your remaining capital balance will be protected.
3. Consider Implementing a Drawdown Cap
Beyond the stop loss features, you should also consider implementing a drawdown cap. This is where you choose how much you’re willing to lose per week or month before you walk away.
Perhaps you’re only investing 1% of your capital balance each trade; if you decide that you’ll only accept a drawdown of 5% then you know that as soon as you reach that limit, it’s time to stop.
This is a great way to monitor your risk and remain calm and controlled. You may decide that’s enough for the week, or that’s enough for that month – it’s about creating your own rules and adhering to them.
4. Keep Your Risk Low
It may feel tempting to blow your capital balance on a big trade; particularly if you’ve recently been hit by a series of bad trades and your capital balance is significantly reduced. But the most effective forex traders keep their trades small. Rather than focusing on set financial figures, they use a percentage of their capital balance. Not only does this reduce their risk of experiencing big losses, but it helps them to remain far more profitable over the long term.
If you start at £10,000, you may think that it’s ok to trade 10% (or £1,000) – after all, the bigger the trade, the bigger the profit.
But, if you lose it, you’re immediately down to a £9,000 capital balance.
If your strategy is to trade 10% each time, what would happen if you experienced 8 to 10 losses in a row? You would very quickly be out of forex trading because your capital simply wouldn’t have enough balance to continue.
This is why many forex traders prefer to trade only 1% of their capital balance. Depending on how large their balance is, this could be a small financial sum or a large figure. But it means that they can retain control and have confidence that they aren’t losing large amounts of their capital balance.
If you are in a drawdown slump, some forex traders recommend reducing your risk even further.
If you reduce your risk for each subsequent trade, you will have a much softer journey. Once your slump starts to end and you’ve won three or four trades back-to-back, you can start to rebuild your confidence and increase your risk in a bid to recoup your capital balance.
5. Keep Calm and Carry On
When it comes to forex trading and forex drawdown, you should prevent emotions from getting the better of you.
It may feel easy to try and recoup your losses by ‘revenge trading’ or ‘overtrading’ but it’s undoubtedly the most dangerous option. This is where you start to increase your risk in a bid to win back the balance that you’ve lost.
This is the worst thing that you can do. The odds may not stack in your favour, and all that is likely to happen is that you will crash and burn fast.
If you are in a slump, you should try changing your perspective. It’s never nice to lose money but it shouldn’t be the be-all and end-all.
Consider thinking about whether the loss will impact you day-to-day. If it will then you’ve over-traded. If it doesn’t then you can simply take a break, walk away and come back refreshed in a week or two.
6. Remember Your Long-Term Strategy
When it comes to forex trading and forex drawdown, you always need to think of the long-term strategy behind what you are trying to achieve.
Are you trying to build up your capital balance little by little or is there something specific that you’re aiming for? Knowing what you want to do will keep you on track and allow you to make informed decisions, which will not just reduce your risk but could actively improve your chances of success.
We hope that this article has given you a small insight into the intricacies of forex drawdown. There’s a lot to think about but, if handled correctly, these insights should help to minimise your risk and help you make the most of your forex trading strategies.
WikiJob are not financial experts. We would always recommend that you always do your due diligence and equip yourself with as much knowledge as possible before getting involved in any form of forex trading.
WikiJob does not provide tax, investment or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.