In this article, we will discuss how you can handle Drawdown in forex. Drawdown is a term that refers to the amount of money that a trader has lost in a given day or period.
Drawdown meaning
A drawdown is a peak to trough decline during a specific period for a trading account, investment, or fund. A drawdown is quoted as the percentage between the peak and the trough. If a trading account has $100,000 in it, and the funds drop to $90,000 before moving back above $100,000, the trading account witnesses a drawdown of 10%.
Drawdowns are essential for measuring the historical risk of investments, monitoring personal trading performance, and comparing fund performance.
What is Drawdown in Forex?
When it comes to Forex, Drawdown is referred to as the difference between a high point in the balance of a trading account and the next low point of an account’s balance. The difference in the balance reflects lost capital due to lost trades.
When an investor loses money on trades, they have what is known as a “drawdown. For example, suppose that a currency trading account begins with a balance of $100,000. The investors work their trading system, and after a bad trade, they see their account’s equity drop to $95,000. Their account has experienced a $5,000 drawdown.
Forex drawdown formula
P = Peak Balance
L = Lowest Balance (valley)
Understanding the Drawdown percentage forex
A drawdown percentage is the portion of a retirement account that a retiree withdraws yearly. If your drawdown percentage is very high, you will outlive your savings and have a financial struggle at the end of your life. You will die with money left over if your drawdown percentage is very low.
Drawdown percentages can be hard for individuals to calculate accurately. Many financial experts find it easy to under-calculate or over-calculate how much money a retiree needs to live on through retirement. To combat the complexity in determining how much a person needs to live on annually in retirement, a common rule of thumb is to take 5% or 4% of the principal amount saved annually, adjusted for inflation. The 4% rule maximizes one’s chances of having enough funds to last to the end of one’s life.
A drawdown of 4% is based on the historical investment performance of a portfolio made up of 50% stocks and 50% bonds and historical inflation rates. It is predicted to ensure that the retiree’s nest egg lasts a minimum of thirty-three years and a maximum of fifty years.
The acceptable Drawdown in forex trading
it is recommended for traders and investors that Drawdown should be kept below a 20% level. By setting a 20% maximum drawdown level, investors and traders can trade with peace of mind and make meaningful decisions in the market that will protect their capital in the long run.
How to handle a drawdown in Forex
There are a few ways to handle a drawdown in Forex. The most important thing is to be patient and stay calm, as the market will eventually correct itself. Below are ways for you to handle a drawdown.
Keep risk low
What would happen if you lost 25 trades in a row?
Think about the loss for a moment. Take the percentage you have been risking per trade, multiply it by 25 and see what you get; it’s over 100, which is a serious problem you need to tackle.
At some point in Forex’s trading career, traders will experience a drawdown period. And if you trade long enough as a trader/investor, there will be a time that you have experienced a quite severe drawdown.
I am not implying that you lose 25 trades in a row at some point. Nobody knows what tomorrow will bring, let alone several months from now.
However, if, as a trader, you aren’t in a position to lose 25 trades in a row and still have capital, you should reconsider the strategy you are using.
There’s no universal answer to how much money you should risk per trade here, but It points down to your tolerance for risk, which you alone can determine.
Reduce the risk of losses persist
When traders find themselves in a trading slump, they have three choices. The first choice is to continue risking the same amount per trade. While this choice isn’t the worst of the 3, it also isn’t going to help the trader turn things around.
Option number 2 might seem like the worst offender, but it’s also what most Forex traders/investors do in drawdown situations. Instead of maintaining the same risk level as losses persist, they try to make back the money they lost by increasing their risk.
This act is known as ‘revenge trading’ in the trading world. These traders/investors increase their risk from 2% to 5% (or even higher) in a desperate attempt to recover lost money.
The third choice is to reduce the risk per trade with each subsequent loss. It guarantees traders a soft landing rather than a crash experience during a drawdown period. Once traders regain their confidence, they can increase the risk per trade to its original level. It usually occurs after two to five winning trades.
Set a drawdown capital
It is arguably one of the most difficult steps to follow. Sometimes it will feel like the entire market is against you. If you haven’t experienced this as a trader already, it’s only a matter of time before you do.
One way to prevent continuous losses when you’re off your game is to set a weekly or monthly capital. By setting your risk per trade, you can establish a drawdown capital.
If it all fails, walk away.
As a Forex trader or investor, you must choose your battles.
Day in and day out, traders are at the mercy of the markets. Sure, traders can choose the setups they take, including exit points and the amount they risk, but the price action is out of their hands.
But there is one thing traders can control every single time. Whether or not they act.
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If things aren’t going as planned, you can take a break from trade.
That’s a powerful position, yet so few traders/investors take advantage of it.
When faced with a drawdown, most investors/traders need to try harder. They want to return the funds they just lost as quickly as possible.
But the Forex market has a peculiar way of working. The harder they try, the more the market resists. And at more than $6 trillion per day in volume, the market always wins.
If losses continue to pile up even after reducing risk and the trading frequency, walk away. Spend time with your loved ones and family or watch your favorite sport. Whatever you choose to do, ensure to stay away from your charts.
After a full week off, come back to check your charts. You will wonder how a brief hiatus from trading can help you bounce back better from a losing streak.
How traders deal with drawdowns
Traders should always be aware of the potential for drawdowns and take steps to minimize them. Additionally, traders should be prepared to deal with significant losses in a short amount of time, and use whatever methods necessary to protect their positions.
- Manage Drawdown by applying the 2% Rule
The 2% rule refers to traders keeping their risk low and using only 2% of their capital on any forex trade.
For example, if two investors start with $10,000 in their trading account and both suffer a loss of 5 bad trades, but trader A only risks 2% per trade, and trader B takes on a higher risk of 5%. In this case, trader A suffered a drawdown of 9.6%, and trader B suffered more than double the Drawdown (22.6%).As to trader B, trader A would need a smaller percentage gain to get back his loss and approximately 30% gains to break even.
- Take Emotional Control of DD Ups and Downs
The 2nd rule for a long-term trading career is to learn to control the psychological turmoil that comes with Drawdown. The 1st step is to take responsibility for your trading decisions. Therefore, traders must hold themselves accountable for their forex trades and determine a course of action to repair their mistakes.
Large drawdowns don’t happen overnight; they start with a smaller drop in your account equity curve. Suffering a drawdown can be an emotional disaster for many traders when money is on the line. It is considered an added stress level that usually leads to more mistakes when trading and subsequent bigger drawdowns.
Knowing how to control one’s emotions while one suffers a drawdown can limit the losses one takes moving forward. A powerful technique to be emotionally detached from losses is to step back for one to two weeks, clear your mind and come back with a fresh mind. While this might not seem pleasant, taking trading breaks allows traders to regain control over their emotions, trading plan, and trading strategy.
- Take One Trade at a Time
The perfect way to reduce the Drawdown in Forex is to limit the trading activity to only one trade at a time. If traders only take one trade at a time and keep the level of risk at 2% per trade, in the worst-case scenario, they will only lose 2%. They can stick to trading only that FX pair if they know their favorite currency (GBP/USD, EUR/USD, etc.).
- Rank Trades based on Profitability
Rank trade setup based on Profitability and keep the level of risk low on the low probability trades. If traders have fewer favorite price action patterns and they still believe it’s worth giving it a try, they can do 2 things:
1. Reduce the stop loss level,
2. Risk less on these trade setups.
- Set a Daily Loss Limit
Setting a maximum daily loss limit is capping the losses on a single day to a certain level. When the daily loss limit is reached, traders will have to stop trading for the rest of the day and only start resume trading the following day. As a rule of thumb, experienced traders use a 4% – 6% daily loss limit.
If, as a trader, your daily loss limit is hit too frequently, that’s not a sign for you to increase your daily loss limit. A more appropriate solution would be to either lower your position size per trade or you will need to go back to a demo account and figure out what’s wrong with your trading strategy.
Even the experienced forex traders and the big hedge funds return to their drawing board when they perform poorly.
- Use GSLO (Guaranteed Stop Loss)
Another way to reduce Drawdown is to use a guaranteed stop-loss order. The GSLO safeguards trade by ensuring the stop loss is executed at the desired price without slippage.
For example, if Ben trades USD/EUR and has the stop loss set at 1.1750 no matter the market volatility, Ben’s 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.
FAQS
Q. What is drawdown risk?
A. Drawdowns present a particular risk to traders/investors when considering the uptick in the share price needed to overcome a drawdown
Q. How do you control a drawdown?
A. Keep risk as low as possible.
Reduce risk of losses persist.
Set a drawdown capital.
· If it fails, walk away.
Q. What is a leverage drawdown?
A. Leverage is a double-edged sword, it magnifies profits, and it amplifies losses. In the financial markets, holding positions for longer periods exposes a portfolio to market risks that can increase drawdowns.
Q. What is a good drawdown ratio?
A. A good drawdown ratio depends entirely on individual risk tolerance or personality type. An aggressive investor or trader can tolerate a higher-level drawdown, whereas a conservative trader will tolerate a lower level of Drawdown. It is recommended for traders and investors that Drawdown should be kept below a 20% level. By setting a 20% maximum drawdown level, investors and traders can trade with peace of mind and make meaningful decisions in the market that will protect their capital in the long run.
Conclusion
Drawdown is an important Forex technical analysis metric that can help you understand how your trading strategy is performing. However, it is important to handle the Drawdown responsibly, as it can result in losing money if not managed properly.
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