What is Drawdown in Forex?
Drawdown (DD) is the difference between the high point and the subsequent low point of your trading account’s balance when it comes to Forex trading. Your balance difference shows lost money from unsuccessful deals.
You can use a drawdown on just one position. The drawdown will occur when the buy-sell price drops below your entry price or when assessing the overall health of your portfolio. To do this, add your winning and losing positions to find the moment your portfolio’s balance drops to its lowest level.
Consider the scenario when your forex trading account opens with a $100,000 balance. You use your trading strategy, and after a loss in trade, you notice that your account’s equity has decreased to $75,000 in total. You succeed in increasing your account from $75,000 to $90,000 after a few more days and make a profit once more. There has been a $10,000 or 10% drawdown on your account.
Causes of Drawdown
There are a number of factors for the forex drawdown. However, the following list includes the most frequent ones:
- A significant decline might result from only one failed trade.
- Taking on too much risk compared to the money in your trading account
- Large equity drawdowns can occur during periods of volatile markets.
- Large drawdowns may result from unpredictable events like black swan events or flash collapses.
- Not employing risk management techniques to limit drawdown
- Overtrading is when you place too many transactions and go against your trading strategy.
Types of Drawdown in Forex Trading
Drawdown can be described using maximum, relative, and absolute terms. The absolute drawdown, relative drawdown, and maximum drawdown are all considered in the best analysis of a trading strategy’s historical performance.
The various types of drawdowns might assist us in calculating the probable capital loss we might experience if we used that specific trading technique.
Your actual loss is a relative drawdown. As long as you hang onto your position, drawdowns are only momentary and only become realized when your stop loss is reached, or you close your position.
For instance, the floating drawdown is the total loss on all active trades at the moment. A floating drawdown is the maximum movement of the price away from your position while the forex trade remains open. Furthermore, that drawdown turns into a fixed drawdown as soon as the lost transactions are closed. The maximum and absolute drawdowns are fixed drawdowns.
Let’s suppose with a $12,000 account balance, you created two positions in the EUR/USD currency pair. Now your account equity was $11000 in the 40 minutes, but it increased to $12,500 in the second hour. Assume that the minimum and maximum values are, respectively, $11000 and $12,500. Then your relative drawdown is what separates them.
The formula for Relative Drawdown is:
Relative Drawdown= Equity Maximum Value-Equity Minimum Value
The relative drawdown can also be calculated in terms of percentage. The formula is as follows.
Relative DD %= (Maximum Equity-Minimum Equity) / (Minimum Equity) ×100
The difference between the initial deposit and the lowest point below the deposit level is known as the absolute drawdown. The investment’s initial risk is gauged by the absolute drawdown. The absolute drawdown displays the size of the trading loss in relation to the first deposit. No capital is in danger if the absolute drawdown value is zero. Following is an example.
In a short period of time, you increased your trading balance from $12,000 to $17,000. But tragically, for some reason, your account balance decreases from $17,000 to $12,000. Your account has now reached the breakeven point. Since trading begins with the beginning balance and finishes at the breakeven point, the total absolute drawdown will thus be zero.
Thus, the formula for Absolute Drawdown will be.
Absolute Drawdown=Initial Deposit – Maximum Loss in Initial Deposit
The formula in percentage is.
Absolute DD %= (Initial Deposit – Maximum Loss in Initial Deposit)/ (Initial Deposit) ×100
The most prominent loss measured from peak to trough right before the next peak establishment is known as maximum drawdown. The maximum drawdown examines the downside risk over a specific time period as a signal. It is the measure of the largest movement from a high to a low position in a portfolio before a new height is attained. But it’s important to remember that, as the max drawdown formula implies, this indicator only assesses the size of the biggest loss in a portfolio.
For instance, in a few months, your trading account balance will increase from $12,000 to $28,000. The account amount decreased multiple times during this time period compared to the starting level, with a maximum fall of $10,000. Now the maximum drawdown is $18,000.
The formula is as follows.
Maximum Drawdown= All time equity high-All time equity low
In Percentage Formula:
Maximum DD %= (All time equity high-All time equity low) / (All time equity high) ×100
Significance of Drawdown in forex
Because drawdown is a parameter that aids forex traders in determining the volatility of account balances, it is crucial to measure it. In other words, it will indicate the size and rate of the decline in your account equity following a losing trend.
A good metric for assessing a trading system’s performance is drawdown. A trading strategy with a significant drawdown, for instance, implies a high-risk and volatile trading technique. Retail traders can more accurately assess whether a trading strategy meets their risk appetite and investment objectives by calculating the Forex drawdown. Overall, the greater the currency drawdown, the greater the swings in your account balance will be.
How to control drawdown?
The Forex trader must implement a sound risk management plan in order to manage drawdown. Risk management refers to your average trade risk. There is no assurance that you will win every time you trade. You will occasionally succeed as well as occasionally fail. However, it is possible to have a sequence of unsuccessful trades, which may negatively affect your trading results and trading account. You must employ a risk-management plan that involves placing 2% or less of your capital at risk on each trade in order to deal with this scenario. You can better control your drawdown by doing this.
Intuitive chart analysis and data interpretation are frequently used in forex trading to determine the drawdown. The most effective weapon in an investor’s toolbox is frequently having a great sense of risk due to the extremely volatile nature of the market. Maximum Equity Drawdown is the most crucial metric for determining a strong portfolio, hence measuring it is of utmost importance. Absolute drawdown is a great way to gauge how well we did in the early stages of trading and compare it to the opening balance. However, for long-term portfolio analysis, maximum and relative drawdown are considerably better choices.