So you want to know what is drawdown in forex?
In this article, you’ll be able to discover the meaning of drawdown and how you can manage it.
After reading this article, you’ll be able to never worry about what it means for you as a trader again.
Let’s check it out:
What is drawdown in forex?
A drawdown refers to a percentage decline in the value of a trading account between the highest peak of the account to the lowest point, it is the lowest point of the account which is the drawdown.
Drawdowns are what traders typically want to avoid, and what motivates traders to stop trading when their trades go against them. However, what causes drawdowns is what will also allow traders to get back on top, and make conditions better than before.
Drawdown can be a trader’s worst enemy. The two main causes of drawdowns in forex trades are the volatility of the market and what happens when prices move too quickly for what you have invested. When there is high volatility in the market this forces what is most likely to become larger drawdowns. However, what creates these periods also allows traders to get out of bad trades faster than ever before. As volatility increases, so does the risk for better trade opportunities.
Drawdown is the amount of a loss in an investment fund or account. For example, suppose you have $1,000 invested in what you think is a high-growth stock that’s worth $2,000. If the company tanked and its shares are now worth $500, your capital would be down to $750 (i.e. if you sell for what they’re worth). Your drawdown would then be 50%.
A good way to measure what your drawdown is at any point in time is by dividing what your account balance will be when it’s closed by what it was when it started. Thus:
If my account balance is $1,000 and I had an initial balance of $1,000, my drawdown is zero.
If I started with $1,000 worth of shares and now have $500 worth of shares, my drawdown is 50%. $500/$1000 = 0.5.
Types of drawdowns and how they affect your trading
Your standard drawdown reviews your account’s peak-to-trough decline. This is what we have covered already and is seen on a bigger scale.
Another type of drawdown in forex trading is the measurement between a trades lowest point and highest point.
So if the market traded 10 pips below your entry-level and traded 40 pips higher, but you didn’t take profit or it didn’t hit your take profit level, this would be known as the drawdown on a specific trade. This would give you a 50 pip drawdown from the peak of the trade.
If the timing of the trade is not great, you could have a larger drawdown than necessary. This is caused by the market hovering below your entry-level and towards your stop loss. This is also considered a drawdown of the individual trade.
If your stop-loss is 50 pips away and the market traded 40 pips below your entry-level, the drawdown is 40 pips. This means the timing of the trade was off and can usually panic most traders as it is close to the stop loss.
On the other hand:
If the trade ticks down 5-10 pips that is considered a low drawdown and your timing of the trade was almost perfect.
This is preferred because emotions and panic won’t set in because of a drawdown on the trade.
At the end of the day, drawdowns aren’t too much of a big deal.
They can give you insight into your trading timings, or your current trading performance.
If you are consistent with your trading and following a plan that you know works, drawdowns become insignificant.
To be honest, it’s best not even thinking about this measurement.
Otherwise if you focus on this, and trying to rush trade set ups to ensure the drawdown disappears – you commonly find that the reverse happens.
More mistakes, worse timing for entry, quickly going against your intuition.
How to deal with a drawdown and make it work for you instead of against you
When you hit a drawdown at some point in your trading journey it’s important to understand why.
There are reasons why traders fail and that is because they simply do not reflect on their trading.
If you have hit a drawdown but kept trying to buy an asset because on the 15 minute chart it’s showing a clear buy opportunity, you may have missed that the larger and more powerful trend is downward.
If you keep repeating the same mistakes, you’ll lose money.
That is why, after each trading day or each trading week as a minimum, it’s imperative to review your trades.
It will not only help your future analysis but also pin point areas where you misjudged the markets, and hopefully uncover a lesson from the mistake.
The best way to deal with a current drawdown is to step back, review all the trades that have gone wrong and that have gone right.
Then take a longer term chart that the one you use to trade from.
So if you trade on the 5 minute chart, take it to the 1 hour chart.
If you trade the 1 hour chart, take it to the daily.
Redraw your support and resistance levels and trends from the higher timeframe.
This gives you a blank slate as well as learning the larger immediate trend before your timeframe.
You can use this as a reset method.
Then forget about the past losing trades and trade with the higher timeframe trend.
That means, only take sell opportunities if the larger trend is bearish and vice versa.
Once you have regained your momentum and easily picking up pips again, continue how you normally trade.
By then, you’ll be out of the drawdown dip and building momentum again.
What is a drawdown in forex: Conclusion
In conclusion, drawdowns are something that all traders and investors have to deal with.
Being prepared for what could happen in the future is key to dealing with your drawdowns.
It’s not a secret how frustrating drawdowns can be, especially for beginner traders.
In order to deal with them efficiently, you need to learn what they are and what causes them before making any trading decision.
The most important thing is to always have patience and stay calm during these difficult times as if you don’t have these two skills, a small loss will quickly turn into an unmanageable one.