Drawdown and Maximum Drawdown Explained

Drawdown refers to the decrease in value of an investment or trading account from its peak to its lowest point, before a recovery to a new high. In forex trading, a drawdown is the difference between the balance of an account and the net equity, and it is typically expressed as a percentage.

Maximum Drawdown (MDD), also known as the maximum peak-to-trough decline, is the largest percentage decrease in account equity from a peak to a trough, before a new peak is achieved. It is a measure of the largest loss that an investment or trading strategy has sustained. MDD is an important metric for risk management and assessing the performance of trading strategies.

why understanding drawdown is important?

Understanding drawdown is important for several reasons:

1. Risk management: Drawdown is a measure of the risk of an investment or trading strategy. A high drawdown indicates that there is a higher risk of losing money. By understanding drawdown, traders can better manage their risk and adjust their trading strategies accordingly.
2. Performance evaluation: Drawdown is an important metric for evaluating the performance of a trading strategy. A strategy with a high drawdown may not be suitable for all traders, especially those with a lower risk tolerance.
3. Psychology: Drawdown can have a significant psychological impact on traders. It can be difficult to stick to a trading strategy during a prolonged period of drawdown. By understanding drawdown, traders can better prepare for it and develop a plan for how to manage it emotionally.
4. Capital management: Drawdown also helps us to understand the capital management of the strategy. A strategy with a high drawdown may require a larger capital to withstand the drawdown as well as to have enough funds to continue trading.

Overall, understanding drawdown can help traders make more informed decisions about their trading strategies, better manage their risk and evaluate their performance.

a simple example of drawdown:

Let’s say you start with a trading account balance of $10,000. The balance of your account increases to $12,000 over the next few weeks. The drawdown at this point is 0% because the balance has not decreased from the peak value.

Later, the balance of your account decreases to $11,000 due to a losing trade. The drawdown at this point is 8.3% because the balance has decreased by $1,000 from the peak value of $12,000.

then the balance of your account decrease to $9,000 due to another losing trade. The drawdown at this point is 25% because the balance has decreased by $3,000 from the peak value of $12,000.

In this example, the maximum drawdown (MDD) would be 25% because it is the largest percentage decrease in account equity from a peak to a trough.

Brokers roles in drawdowns

Brokers are related to drawdowns in several ways:

1. Margin requirements: Many brokers require traders to maintain a certain amount of margin in their trading accounts. If the value of the account falls below the margin requirement, the broker may issue a margin call, which requires the trader to add more funds to the account or close some positions to bring the account back above the margin requirement.
2. Stop-out level: Some brokers have a stop-out level, which is the level at which the broker will automatically close a trader’s positions if the account balance falls below the level. This can help prevent the trader from suffering a large drawdown.
3. Leverage: Brokers typically offer leverage to traders, which allows traders to trade with more funds than they have in their account. Leverage can magnify both gains and losses, so it can also increase the risk of large drawdowns.
4. Trading rules and regulations: Different brokers might have different rules and regulations when it comes to managing the risks and drawdown. This can be important to be aware of and to make sure that the broker is providing the necessary tools and support to manage the drawdown.

Overall, brokers play an important role in managing the risks associated with trading, including drawdowns, by providing margin requirements, stop-out levels, leverage and other tools and support.

Leverage and drawdown relationship

Leverage and drawdown are closely related in the sense that leverage can increase the potential for both gains and losses. Leverage allows traders to trade with more funds than they have in their account, thus magnifying any gains or losses. This means that leverage can increase the potential for large drawdowns.

Leverage can be thought of as a double-edged sword. On one hand, it can increase the potential for large gains, but on the other hand, it can also increase the potential for large losses. The use of leverage increases the risk of drawdown because traders are able to open larger positions than what their account balance can support.

For example, if a trader has a $10,000 account balance and trades using leverage of 10:1, they can open a $100,000 position. If the market moves against the trader, the potential loss can be much greater than if the trader had not used leverage. In this example, if the market moves 1% against the trader, the loss would be $1,000, which is 10% of the account balance.

Therefore, it is important for traders who use leverage to carefully manage their risk, have a solid trading plan and be aware of the potential for large drawdowns. Additionally, it is important for traders to keep in mind that the use of leverage can amplify the effects of volatility in the market and should be used with caution.

What You Can Learn From a Drawdown?

There are several things you can learn from a drawdown in your trading:

1. Risk management: A drawdown can teach you about the level of risk associated with your trading strategy. By understanding the maximum drawdown of a strategy, you can better assess its risk and adjust your risk management accordingly.
2. Strategy evaluation: A drawdown can help you evaluate the performance of your trading strategy. A strategy with a high drawdown may not be suitable for all traders, especially those with a lower risk tolerance.
3. Capital management: A drawdown can help you understand the capital management of your strategy. A strategy with a high drawdown may require a larger capital to withstand the drawdown, as well as to have enough funds to continue trading.
4. Psychological impact: A drawdown can also teach you about the psychological impact of trading. It can be difficult to stick to a trading strategy during a prolonged period of drawdown. By understanding drawdown, traders can better prepare for it and develop a plan for how to manage it emotionally.
5. Systematic/unsystematic risk: A drawdown can also give you an idea of how much of it is caused by systematic risk (market risk) or unsystematic risk (unique to the strategy). This can help you to decide if the strategy is still suitable for your investment goals, or if you need to look for another strategy that aligns with your risk appetite.

Overall, a drawdown can provide valuable information about the risk and performance of a trading strategy, as well as the psychological impact of trading. By understanding and analyzing drawdown, traders can make more informed decisions about their trading strategies, better manage their risk and evaluate their performance.

How To Calculate Forex Drawdown

To calculate the drawdown in a forex trading account, you can use the following formula:

Drawdown = (Peak Equity – Trough Equity) / Peak Equity

Where:

• Peak equity is the highest value of the account equity achieved during a certain period.
• Trough equity is the lowest value of the account equity achieved during that same period.

For example, let’s say the highest value of the account equity achieved is $10,000 and the lowest value is $9,000. To calculate the drawdown, we would use the following formula:

Drawdown = ($10,000 – $9,000) / $10,000 = 0.1 or 10%

This means that the drawdown of this account is 10% over a certain period.

To calculate the maximum drawdown (MDD), you can look for the highest peak equity and the lowest trough equity over a period of time, compare them and use the same formula above.

It’s important to note that the period of time you choose to calculate the drawdown can affect the results, shorter periods will give you a more precise but short term view of the drawdown, while longer periods will give you a long-term view but with a less precision.

Also, there are several tools and software that can help you calculate the drawdown, such as Excel or trading platforms like MetaTrader, which have built-in functions to calculate drawdown.

Recover From Forex Drawdown

Recovering from a drawdown in a forex trading account can be challenging, but there are several steps you can take to help you bounce back:

1. Stick to your trading plan: A drawdown can be a test of your discipline and emotional control. It is important to stick to your trading plan, even during a drawdown. Avoid impulsive trades and stick to your risk management rules.
2. Stay patient: Recovering from a drawdown takes time. You should be prepared for the recovery process to take weeks or even months. It is important to stay patient and not to make decisions based on emotions.
3. Review your strategy: Take a step back and review your trading strategy. Analyze what went wrong, and make adjustments where necessary. Also, consider if your strategy is still suitable for your investment goals, risk appetite and market conditions.
4. Capital management: Review your capital management, make sure you have enough funds to withstand the drawdown, and avoid overleveraging.
5. Take a break: Sometimes taking a break from trading can help you clear your head and come back to trading with a fresh perspective.
6. Learn from the experience: Drawdowns are a natural part of trading, and it’s important to learn from the experience. Look at what went wrong and what you could have done differently. Use the experience to improve your trading skills and increase your chances of success in the future.

It’s important to remember that drawdowns are a normal part of trading, and it’s not uncommon for traders to experience them. By following these steps, you can bounce back and recover your account.

What Is Relative Drawdown?

Relative drawdown, also known as relative equity drawdown (RED), is a measure of the risk of a trading strategy compared to a benchmark or a reference index. Unlike the traditional drawdown that measures the absolute decline in an investment or trading account balance, relative drawdown compares the decline of an investment or trading account with a benchmark or reference index.

Relative drawdown is calculated by comparing the cumulative performance of a trading strategy to a benchmark or reference index, and measuring the largest percentage decline of the strategy relative to the benchmark or index. It is expressed as a percentage and can be used to assess the risk of a trading strategy compared to a benchmark or index.

For example, if a trading strategy has a maximum relative drawdown of 10% and the benchmark has a maximum relative drawdown of 20%, it means that the trading strategy performed better than the benchmark, as it had a lower relative drawdown.

Relative drawdown is a useful tool for evaluating the performance of a trading strategy and comparing it to a benchmark or index. It can be used by traders to assess the risk of a trading strategy and make more informed decisions about their trading strategies.

Why You Need To Keep Drawdown Under Control?

1. Return on investment (ROI): Drawdown can significantly affect the return on investment (ROI) of a trading strategy. A high drawdown can reduce the overall ROI of a strategy, even if it eventually returns to its previous high. By keeping drawdown under control, traders can maintain a higher ROI and achieve better returns over time.
2. Compounding: A high drawdown can reduce the compounding effect of a trading strategy. By keeping drawdown under control, traders can maintain a higher compounding effect and achieve better returns over time.
3. Diversification: A high drawdown in one trading strategy can affect the overall performance of a portfolio of strategies. By keeping drawdown under control, traders can maintain a better diversification of their portfolio, reducing the impact of individual strategies on the overall performance.
4. Withdrawals: A high drawdown can affect the ability to make withdrawals from a trading account. By keeping drawdown under control, traders can maintain a better liquidity and have more flexibility in making withdrawals.
5. Confidence: A high drawdown can affect a trader’s confidence in their trading strategy. By keeping drawdown under control, traders can maintain a higher level of confidence in their trading strategy, which can lead to better decision-making and ultimately, better performance.

In summary, keeping drawdown under control is critical for managing the risk and maximizing the returns of a trading strategy, as well as preserving capital, maintaining a positive psychological attitude and evaluating the performance of a trading strategy. It’s also important for compliance, diversification, withdrawal flexibility, and trader’s confidence.

Drawdown Trading Strategy To Control Drawdowns

this is a list of specific strategies for controlling drawdown, with recommended values where applicable:

1. Risk/Reward ratio: Set a target risk/reward ratio of at least 1:2, which means that for every dollar risked, the target profit should be at least two dollars. This can help to ensure that potential gains are at least twice as large as potential losses, which helps to control drawdowns.
2. Position sizing: Use a fixed fractional method, where no more than 2-3% of the trading account is allocated to any single trade. This can help to limit the potential loss from any single trade and control drawdowns.
3. Trailing stop-loss: Use a trailing stop-loss of 20-30 pips on each trade. This can help to lock in profits while limiting potential losses.
4. Diversification: Diversify the portfolio by trading different markets, instruments, and strategies. This can help to spread the risk across different markets and reduce the impact of any single trade on the overall performance.
5. Cut losses: Cut losses quickly by setting stop-losses at logical levels and not letting losses run too far. A rule of thumb is to cut losses at 8% of the account balance, this can help to minimize the impact of losses on the overall account balance.
6. Re-evaluate strategy: Regularly re-evaluate your strategy, look for any signs of overfitting, or if the market conditions have changed, this can help to improve the performance of the strategy and control drawdowns.
7. Emotional control: Keep emotions in check by having a trading plan, sticking to it and avoiding impulsive decisions that can lead to bigger losses.
8. Risk Management Plan: Have a well-defined risk management plan that includes stop-losses, position sizing, diversification, and a risk/reward ratio. The plan should also include measures to control the emotional aspect of trading.

It’s important to note that these values are only recommendations and may vary depending on the individual trader’s risk tolerance, investment goals, and market conditions. It’s important to test and adjust these strategies to find the values that work best for you.

Final Thoughts

drawdown is an important metric for measuring the risk of a trading strategy and the potential for losses. It is important for traders to understand and control drawdown in order to manage the risk of their trading strategy, preserve capital, maintain a positive psychological attitude and evaluate the performance of a trading strategy.

There are several strategies that traders can use to control drawdown, such as implementing a solid risk management plan, using position sizing, trailing stop-losses, diversification and setting a risk/reward ratio. Also, traders should regularly re-evaluate their strategy and cut losses quickly. Additionally, Emotional control and having a trading plan are key to success.

It’s important to remember that these strategies and values are only recommendations and may vary depending on the individual trader’s risk tolerance, investment goals, and market conditions. Traders should test and adjust these strategies to find the values that work best for them.