The Meaning of Drawdown in Forex
When it comes to forex trading, drawdown refers to the difference between a high point in the balance of your trading account and the next low point of your account's balance. The difference in your balance reflects lost capital due to losing trades.
When you lose money on trades, you have what is known as a drawdown. As an example, say that your currency trading account begins with a balance of $100,000. You work your trading system, and after a bad trade, you see your account's equity drop down to $95,000. Your account has experienced a $5,000 drawdown.
What You Can Learn From a Drawdown
Drawdowns also describe the likely survivability of your system over the long run. A large drawdown puts an investor in an untenable position.
Consider this: A client who endures a 50% drawdown has a large task and a real challenge ahead of him because he must have a 100% return on his reduced capital stake just to break even on the reduced equity position.
Many investors or fund managers on Wall Street are ecstatic with around 20% profit for the year. As you can imagine, when a trader suffers a drawdown, he's best served by implementing good risk-management procedures and readjusting his system as opposed to trying to aggressively trade his way back to the breakeven point.
Typically, a trader's aggressive approach to get his capital back to break even will have the opposite result. Why? He will most likely become emotional, using leverage and over-trading to get his trading account back to even.
Too Much Leverage
When traders use too much leverage, one bad trade can have disastrous effects—and it often does. In short, traders are either too aggressive or too confident, and this leads to large losses or an unwillingness to accept a trade that is a loser and should be cut. There is an old adage in trading that one trade will rarely make your trading career, but one bad trade can certainly end your career.
What I Learned Losing $1,000,000 by Jim Paul and Brian Moynihan offers some excellent insight if you'd like to read a book that describes the emotional toll of drawdowns.
The book discusses how, by taking a large drawdown, a trader lost his career, significant amounts of his family's fortune, and money belonging to his friends.
The book also shares several tips on how to overcome common pitfalls of trading, such as implementing a trading plan that is likely to be emotionally driven instead of risk-management-driven.
One of the most important and useful tips is to set a predetermined stop-loss point for your trade before entering. This will limit the amount of any drawdown you will take. Avoid making trading decisions based on emotion and, instead, focus on a strategy based on managing risk by exiting trades early enough to minimize your losses.
Once you take these steps, you'll be able to stand back after you've entered a trade, knowing that you're out of it with no questions asked when and if your stop-loss level is hit.
A lot of traders make the mistake of trying to negotiate with the market as to whether they should stay in a losing trade. This is a mistake because you'll be making your trading decisions based on emotion instead of strategy, and you may do the thing that is the least painful at the time, but not necessarily more beneficial down the road.