Drawdown in Forex

Drawdown is an important money management concept for you to understand before you start trading forex live. Good money management is what will make you survive long term in the markets. Money Management allows you to be proactive in managing risks and how to cope with trading losses which are part and parcel of the game. Money management is about fully optimizing your trading capital.

Survival long term is what trading is all about! Preserve your capital. This is your first and foremost duty as a trader. The concept of drawdown is important for you to understand for the preservation of your capital. Preservation of capital is the key to ensuring a trader’s long term survival in the forex market. For without survival there can be no wealth generation.

Every trader has to take losses. Drawdown in simple terms is the amount of money that you lose while trading. Drawdown is usually expressed as a percentage of your total trading equity at any given time. Drawdown refers to the decline in the trading account equity from a trade or a series of trades.

While many new traders dream of a one big win that will magically make them a millionaire overnight. The truth is most of the trader are more likely to be confronted with one big loss that can wipe out their trading account in a short time. However, if you are clear about drawdown, you can avoid such a painful eventuality. Let’s make drawdown clear with an example. Suppose you are starting with $10,000 in your trading account. You lose $2000. Your drawdown would be 20%. Now you have only $8000 in your account. Suppose you gain $1000 and then again lose $3000. Now $9000+$1000-$3000=$7000 are left in your trading account. This represents a loss of 30% on your starting balance of $10,000. So now your drawdown is 30%.

Keep this in mind that drawdown is calculated when you have a losing trade against your new equity high or your original equity whichever is higher. Drawdown is not an indication of your trading performance. Suppose, you make a gain of $4000 instead of making a loss on your opening balance of $10,000! Now the equity in your trading account is $14,000. In the next trade, you again lose $3000. Equity in your trading account now is $14,000-$3000=$11,000.

Your drawdown should be 21% (= $3000/$14000). This is a 21% decrease from the equity high of $14,000 in the trading account. A 100% drawdown will wipe out your equity in the trading account. Always remember the motto, “Survive to trade another day.” For if you lose all your money, you wont be able to double your account. Only those traders flourish in the market long terms who understand good money management rules really well.

Capital preservation is essential for your long term survival in the market. As the drawdown gets bigger and bigger, it become difficult to recover the equity lost. Many people don’t know that in order to recover the percentage of equity that they lose, they will need to gain a higher percentage just to break even. There is no way around recouping slowly. Don’t try martingale strategies. Only if you want to drive yourself to total destruction by risking more and more of your equity to try to make back your losses.

Holding on to a losing trade for too long is the biggest cause of a big drawdown. If you start losing more and more of your capital, the faster you will go down the drain. Suppose you lose 10% of your trading capital. How much you need to recover? Is it 10%? No! It will require an 11% return on the equity balance in your account to recoup the 10% loss.

Most new traders run out of money even before they see any profits in their trading accounts. When you risk capital on trading, you hope that this amount of money can be transformed into a much bigger amount. But what if you start losing? Let’s make it clear with numbers. Suppose you start with $10,000 equity in your trading account. You lose $1000. Your drawdown is 10%. Now you have $9000 in your trading account. You need to make $1000 to breakeven and recover your loss. This is equal to 11.11% (= $1000/$90000) return on your balance of $9000.

As you can see as the losses increase arithmetically, the gains that are needed to recoup them increase geometrically. If a trader has a big loss, they will have to spend more time to get back to where they were before instead of using the time for making profits. So if you lose 10% of your equity, you will need an 11% return to breakeven. In case of a 20% loss you will need to make 25% in order to breakeven. For a 30% loss, you need 42.85%. For a 40% drawdown you need 66.66%. In case you lose 50% of your equity, you will have to make 100% return for recovering your loss. For a 60% drawdown, you need to make 150% return. For 70% you need 233%. For 80% drawdown, you have to make a return of 400% or in other words quadruple the account just in order to breakeven. For 90%, you need a return of 900% in order to breakeven. In case you have a 100% drawdown, your trading account is wiped out.