Drawdowns are inevitable and everyone will face Forex drawdowns at some point in their trading career. Without a proper one risk managementdrawing can destroy a trading account even if the overall trading strategy is profitable.
This makes draw one of the most important metrics for performance analysis.
In this article I will take a detailed look at how drawdowns occur and what steps you can take to control them and maximize your chances of trading success.
Small drawdowns will happen regularly as losing trades will be mixed in with winning trades. Smaller withdrawals are a normal part of business life.
However, if I have a bigger losing streak than normal, the drawdowns can go from a minor event to a major event, and that’s when I need to pay attention and adjust my trading.
Withdrawals from the account are not drawn:
A withdrawal is not the same as a withdrawal, i.e. when I transfer funds from my trading account to my bank account. Traders use the word ‘drawdown’ only to refer to a decrease in account value due to trading losses.
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There are three main reasons why understanding Forex drawdown can help you become a better trader:
- Knowing your historical draws will help you predict when your next draw is due. For example, if I know my average pumping is two weeks long, I won’t worry if I’m pumping for one week. This is also valuable knowledge if I rely on my trading for income, as I would rather withdraw when the account is at its highest than withdraw when my account value is low.
- You don’t want to destroy your trading account. When the drawdown is too large, I can “crash and burn” and destroy my account because my capital is too small to trade effectively. I want to know in advance if my account is at risk of being destroyed so that I can adjust my trading so that it doesn’t happen. A wise businessman once told me, “It is necessary to live to fight another day.”
- You want to know the health of your trading. The size and frequency of withdrawals tell me about the health of my trading, even if I am profitable. If my withdrawals are more frequent or larger, it means my trading is not as good as it used to be. The reason may be a change in market conditions. But it could also be because my abilities have declined – whatever the reason, I want to investigate. For example, am I still trading according to my rules? Or am I taking emotional trades that are not part of my strategy?
Absolute withdrawal is measured by how much the account value has fallen below the initial deposit.
It is “absolute” because it always uses the initial deposit as a fixed or absolute value to measure drawdown. This measurement is most useful when you are starting out as a trader, as most early stage traders will want to ensure that they protect some portion of their initial deposit against future losses.
Absolute drawdown is usually reported as a percentage (rather than dollars).
This is the biggest drop in account value since the previous peak. The maximum draw is usually a dollar amount and the relative draw is usually the maximum draw expressed as a percentage.
Note: Draws may not have consecutive losses. Wins may be mixed with losses resulting in a total loss. For example, I could have 2 losses followed by 1 win and 2 more losses. These 5 trades together can create a net loss.
First, I will take the difference between the lowest value the account has reached in its history and the initial deposit. I then calculate the difference between these two values as a percentage of the initial deposit.
The formula for absolute drawdown is:
(Initial Deposit – Lowest Account Value) / Initial Deposit.
To get a percentage, multiply the result by 100.
Let’s look at an example:
Initial deposit: $10,000
The lowest my account is worth: $7,500
The difference between the initial deposit and the lowest historical account value is $2,500.
Expressed as a percentage of the initial deposit, it is:
($2,500 / $10,000) x 100 = 25%.
Can my absolute draw change?
Yes. My absolute draw may change if my account value falls below a previous all-time low.
Note: I’ve seen different definitions of max and relative draw depending on the platform, so my interpretation may differ from others.
As the name suggests, the maximum drawdown means the largest dollar drop in your trading account from the highest point. Some traders also refer to this as the “fall from the peak to the valley”.
Let’s say I changed my account balance from $10,000 to $20,000. I then had a losing streak and my account value dropped to $12,000 before it recovered.
In that case, my maximum withdrawal is $8,000.
Relative drawdown is, simply put, the maximum drawdown as a percentage of the highest account value.
Using the example above, if the account peaked at $20,000 before falling to $12,000, then the relative drawdown would be 40% because the account dropped 40% from $20,000 to $12,000.
Said as a formula, it is:
($20,000 – $12,000) / $20,000 = 0.4 or 40%.
Let’s say I’m at a new high in my account and then I open a new trade. The trade goes 70 pips in my favor, but it’s going down a bit. I ended up closing the trade for a profit of 50 pips. Using this example, let’s see how I can calculate drawdown using open equity or closed balance:
- When calculating open capital, +70 pips would represent the new high point in my account value for calculating future withdrawals.
- When calculating the closed balance +50 pips would be the new high point of my account value to calculate future withdrawals.
Some marketers like to divide their metrics into specific time periods. For example, what was the biggest drop this quarter? How does it compare to the previous quarter? This is a smart way to track performance because it tells me if my results are getting better or worse.
If I don’t measure my draw I might not see the damage coming and I might not be sure if it’s a temporary blip or something more serious. The worst part is that I realize it’s a serious loss when it’s too late to repair the damage. I have seen traders whose account balances dropped 70% to 80% before they addressed adjusting their trading. At this point, they need a 300% to 400% profit to get back to their original deposit.
Measuring losses allows you to take preventative action to prevent serious damage before it happens. Measuring your drawdown can also help you act more strategically than emotionally, which can help prevent problems.
Controlling drawdown means controlling risk. Here are five steps that anyone can implement.
- Use a stop loss. Always, always use a stop loss and never extend the stop loss once the trade is open. Stop losses are the basis of risk control because they limit the risk of each trade.
- Goal positive reward to risk ratios. If the trade cannot make more than the size of the stop loss, I will not take the trade. All of my trades have a reward to risk ratio of at least 1.5:1, which means I want to earn at least 1.5 times more than I’m willing to risk. A positive ratio means I’m not relying on a high win percentage to make money. An excellent real-life example is a self-funded independent trader from Sweden, Kristjan Kullamägi, who turned $4 million into $32 million in 2020 with only a 30% win rate. To achieve these returns, he had very high rewards compared to his risk.
- Have the maximum percentage risk per trade in your account. For example, if the maximum risk per trade is 2%, the size of the stop-loss in dollar terms cannot exceed 2% of the total value of the account. If my account balance is $10,000, the trade cannot cost me more than $200 if they stop me. This means I have to calculate the position size for each trade if my stop loss and Forex pair sizes are different for each trade. For example, a EUR/USD trade with a stop-loss of 50 pips will have a different position size than a GBP/USD trade with a stop-loss of 100 pips. It also means that as my account value goes down, so does the dollar value of my stop losses, which further helps protect my account.
- Ensure maximum drawdown before reducing risk further. The temptation is to increase risk after a losing streak because I want to recoup losses faster, but that’s emotional trading. If I’m experiencing a draw, I’m out of sync with the markets. Before going back to my usual level of risk, I should sync with a lower risk. For example, if my account goes down 10%, I will go down to 1% risk and wait for my account to return to the previous equity value before going back to my normal 2% risk.
- Ensure maximum withdrawals before switching to cash. At some point I may be in an area where I can’t stop my account from draining. I want to stop trading and reevaluate before I get to the point where my account is destroyed. For example, if my account drops 30% from its maximum value, I stop trading and examine my method and execution.
Drawdowns will happen to the best traders, so I see them as an inevitable part of trading. That’s okay – there’s no reward without risk. But it is necessary to manage them proactively to balance the drawdown.
Measuring drawdowns is easy and most platforms will easily capture Forex drawdown without the trader having to calculate it manually.
How do I calculate Forex withdrawals?
There are two methods: absolute drawdown, which tracks how much the account falls below the initial deposit, and maximum and relative drawdown, which are peak-to-valley measurements.
How much drawdown is acceptable in Forex?
In general, traders will stop trading if their account drops below 10%-20% of their maximum equity.
What Causes Forex Drawdowns?
A number of losses cause drawdown. This can be due to poor market conditions, emotional trading, poor risk management eg low reward/risk ratio, or poor trading strategy.
What is a good maximum draw?
A good maximum drawdown is generally in the range of 10% to 20% of the maximum equity.