If you have been trading for a while (or if you intend to in the future), you will have experienced some negative trades which could result in a net negative loss on your trading account. This loss is referred to in forex jargon as Drawdown and is expressed as a percentage of your account capital.
A more stronger explanation of forex drawdown can be defined as a percentage of your trading account which can be lost in the event of consecutive losing trades. Forex drawdown is simply a measure of the largest loss that occurs in a trading account.
For example, if your trading account has a capital of $1000 and you lose $500, then your drawdown is 50%.
Drawdown is something that scares most new traders. But it is to be seen only as one of the parameters to measure your risk management.
Importance of Forex Drawdowns
Forex drawdown is an important measure for traders for a variety of reasons. Say for example, you were tempted to buy a forex trading system or an expert advisor which advertises (promises) you a 70% profitable system. While that might seem lucrative, you must also pay attention to the drawdown.
While profits are always focused upon, paying attention to the risk or downside is something that is equally important. Many beginners to forex trading don’t understand the importance of drawdown.
So if the above trading system has a drawdown of 50%, it means that while the EA can make you 70% of profits, it also has a potential to lose half your capital.
Besides using drawdown as a measure on how risky/stable a forex trading system is, forex drawdown can also be used by a trader to see their overall risk management strategy. For example, if you have inconsistent drawdowns month on month, then you need to focus on manging your risks better. Which brings us to the next section.
Reasons why Forex drawdowns happen
At a broad level, forex drawdown happens because of a losing trade. To be more specific, when you close an open position that is in the negative.
Bear in mind that there is no trading system that make you 100% consistently profitable trades. Therefore, forex drawdown is something you will experience at some point.
How to better manage forex drawdowns
Stops – Using stop losses and trailing stops or using pending stop orders is one of the factors to limit your losses. However, incorrect use of stops can actually limit your profit taking capabilities in your trades as well.
There are many resources on the internet that tell you how to set your stop losses or trailing stops. But the best way to learn how to use stops is to try it out on a demo account yourself. I’m certain that within a few weeks you will start to get familiar in finding the optimal stop settings.
Lot Size – Also referred to as position, incorrect usage of lots in relation to your leverage and account capital can lead to big spikes (both in profits and losses).
While there is no one setting that works best, this is yet again something that you can only learn when you start trading. A big no however is to risk more than 2% of your capital. So what does this mean?
Using stop loss to limit forex draw down
One of the most basic yet often ignored subject in forex trading happens to be that of using Stops (Buy/Sell Stop Orders & Stop Losses). This is in fact one of the most fundamental aspects towards good risk management. Yet, traders often tend to focus on take profits, rather than stop losses.
While traders do make use of stop losses, setting them up incorrectly is a problem. It can prove to be disastrous and is as good as not using stop losses at all. The failure use of stops in forex trading is quite fundamental. It comes due to the misconceptions that a losing position could reverse and head back into profits. However, the truth is far from it.
Most traders, take up a position based on the fact that they expect every trade to be a profit.
This is because traders think that the forex markets works not on uncertainty but rather as possible outcomes with various determining inputs such as good news, bad news and the relative market behavior. The fact is that we don’t really know how the price of an instrument would react to the news.
It is possible and can be seen especially when you are trading news related events that despite ‘good news’ prices, at times tend to react in the opposite direction to your expectations.
Losses in forex can be attributed to two factors. The first being a trader’s mistake such as failure to apply the system or impulsively entering a trade. The second being the case where despite getting everything right, the trade can result in a loss, this is mostly a part and parcel of forex trading and should be seen as a tribute to the uncertainty in the forex markets.
How to effectively trade with Stops (Buy/Sell Stop Orders)
Trading with stops is something that is vital to a trader’s performance. Stops help you to get into a trade at an opportune time. It is also useful to cut your losses quickly. As a result, stops preserves your capital. This is even more important for traders who tend to trade on high margin and leverage.
Trading without setting up stop losses is akin to trade with your ego thus not wanting to be accountable and to admit that a position that you entered was a mistake. Also, traders tend to view stop losses as an exit strategy for your trades. This is incorrect however.
Trading with stops also includes Buy/Sell Stops as well, which is infact the starting point for entering into a trade.
A Buy Stop becomes a market order when the price is bid at or above the stop price, whereas a Sell Stop becomes a market order when the price is offered at or below the stop price.
Traders usually tend to make use of limit orders. The problem with limit orders is that the probability of your order getting executed depends on the price and the prevailing market conditions. Whereas, trading with stop orders gives you the chance to buy or sell when the instrument’s price takes a significant high or when new lows are breached.
Forex Stops help you to determine your risk exposure early
Trading with stop orders and setting up the stop losses helps traders to determine their amount of exposure to the risk early on. Stop losses, or exit losses thus helps to protect your capital. However, it can be a bit tricky when making use of both stop orders and stop losses. Typically, the reward to risk ratio should be approximately three times or more than the risk that you are willing to take.
Once you set up your risk exposure (your risk-reward ratio), you should lock in or protect your profits. This can be done by making use of trailing stops. The ideal setting for trailing stops is under the 10 day EMA during a good uptrend. This is subjective and can vary based on your trading style, indicators being used and so on.
Forex drawdown – Wrap up
If your forex account has $1000, then your trade (if they lose) should not be more than $20. Drawdown is essential part of a trading system. Hence, try to test your trading strategies before using them on a real account.
By following this principle, you are basically limiting your drawdown (on this trade to be specific) to only 2%. But remember, limiting your risk to just 2% on a trade is not enough. A series of losing trades will add up and increase your drawdown.
The key to managing forex drawdowns is to learn the skills of good risk/money management and to also follow a disciplined forex trading system. Most often, there are a few trades that compel us to take a position based on impulse. Such trades can be risky and in most cases is the reason for closing as a losing trade.
While it is important to keep an eye on your drawdown, let this not be a deterring factor. Most often traders tend to abandon their trading account and even the broker (especially true in case of demo trading) when they face extreme drawdowns. In such cases, you can simply ask for additional demo funds to be added to your account.
It will help you to remember the forex drawdown your account. In the future, this will enable you to better monitor your trading strategy.