What is a drawdown on Forex?
There are two main stages in trading on the Forex currency market: the growth of the deposit on the trading account and the receipt of investment losses. When there are a lot of unprofitable trades on the trading account, traders talk about drawdown.
What is Forex Drawdown?
Drawdown in financial markets is a normal situation that a trader should not be afraid of or try to avoid. Trading is a risk of total loss of money, so a moderate loss of 15-20%, if it is controlled by a trader and corresponds to the strategy, is acceptable.
Drawdown (DD) in the foreign exchange market is a decrease in the amount of money on the trading account as a result of opening a loss-making transaction. In simple words, a drawdown is a floating or real loss of a trader.
Types of drawdowns on Forex
There are types of drawdown in the Forex currency market:
Current drawdown. The current drawdown on forex is a temporary drawdown that was formed as a result of open trades that are now in the red. In this case, the amount of the initial deposit does not change, but the amount of funds (equity) will fluctuate depending on the direction of the market. No one knows how this drawdown will be closed — with profit or loss, so it is taken into account when the minus is already very significant. In this case, you need to think about the money management rules of your strategy.
A fixed drawdown is a closed trade with a loss. Fixed or actual drawdown negatively affects the size of the deposit, reducing it by the percentage that was received as a result of closing the transaction.
Maximum drawdown. The maximum drawdown shows the level of maximum deposit losses as a result of closing unprofitable transactions for the entire trading period. For example, the account had three big losses: $300 with a $1,000 deposit, $450 with a $2,000 deposit, and $200 with a $2,500 deposit. The maximum drawdown here will be $ 450.
Relative drawdown. The relative drawdown shows the maximum decrease in the deposit relative to the initial amount, expressed as a percentage. This drawdown is often taken into account when analyzing a trading strategy, it shows what losses the trader who uses it will have.
The absolute drawdown shows how much the deposit balance has decreased compared to the initial value. These data are similar to the relative drawdown, but expressed in the deposit currency.
Why is it necessary to analyze the drawdown?
Drawdown is an important component of a trading strategy. The drawdown percentage shows how risky the trader is trading.
The lower the maximum drawdown, the more conservative the trading system is considered.
Optimal drawdown size
It is difficult to say which drawdown size is considered optimal. It is necessary to take into account many different points: the type of trading strategy, trading deposit, trader’s psychotype, timeframe, asset volatility, etc. But in general there are three indicative criteria:
- A drawdown of 15-20% is normal.
- A drawdown of 21-35% is a dangerous level of deposit losses.
- A drawdown of about 30% is a reason to think about changing the trading strategy and checking it for errors in the risk management system.
- A drawdown of 36-55% is practically a loss of the deposit. It is better to close orders and think about the reasons for such a drawdown.
How to reduce the drawdown on forex?
The main actions to minimize drawdowns are:
- Use Stop Loss. Its size should not exceed 5% of the total amount on the trader’s account. The Stop Loss is set at the moment of opening a new trade.
- Optimal leverage – using a large leverage can lead not only to drawdowns, but also to the loss of a trader’s deposit.
- Not to trade in an unstable market – very often a trader who complies with even the first two conditions still manages to lose almost half of his own funds in one session. Therefore, if you have made several unsuccessful trades in a row, it is better to give up trading for today and do something else.
- Correct assessment of the likely profit – do not be greedy when setting take profit.